Fei (FEIC) 10-Q 2005 Q2 Quarterly report

UNITED STATESSECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

ýQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 3, 2005

OR

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File No. 0-22780

FEI COMPANY

(Exact name of registrant as specified in its charter)

Oregon	93-0621989
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
5350 NE Dawson Creek Drive, Hillsboro, Oregon	97124-5793
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code:  503-726-7500

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ý  No o

The number of shares of common stock outstanding as of August 9, 2005 was 33,662,916.

FEI COMPANY

INDEX TO FORM 10-Q

PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Consolidated Balance Sheets – July 3, 2005 and December 31, 2004
	Consolidated Statements of Operations – Thirteen and Twenty-Six Weeks Ended July 3, 2005 and July 4, 2004
	Consolidated Statements of Comprehensive (Loss) Income – Thirteen and Twenty-Six Weeks Ended July 3, 2005 and July 4, 2004
	Consolidated Statements of Cash Flows –Twenty-Six Weeks Ended July 3, 2005 and July 4, 2004
	Condensed Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II - OTHER INFORMATION
Item 4.	Submission of Matters to a Vote of Security Holders
Item 6.	Exhibits
Signatures

1

FEI Company and Subsidiaries

Consolidated Balance Sheets

(In thousands)

(Unaudited)

	July 3, 2005			December 31, 2004
Assets
Current Assets:
Cash and cash equivalents	$	72,640		$	114,326
Short-term investments in marketable securities	126,166			173,681
Short-term restricted cash	15,640			16,356
Receivables, net of allowances for doubtful accounts of $3,698 and $3,257	116,877			159,761
Current receivable from Accurel	—			515
Inventories	91,976			87,783
Deferred tax assets	2,032			8,365
Other current assets	30,344			29,804
Total Current Assets	455,675			590,591
Non-current investments in marketable securities	57,264			33,850
Long-term restricted cash	4,359			4,177
Long-term receivable from Accurel	—			883
Property, plant and equipment, net of accumulated depreciation of $69,648 and $60,882	65,312			71,550
Purchased technology, net of accumulated amortization of $39,005 and $26,871	9,603			22,080
Goodwill	41,461			41,486
Deferred tax assets	5,415			18,555
Other assets, net	49,076			58,622
Total Assets	$	688,165		$	841,794
Liabilities and Shareholders’ Equity
Current Liabilities:
Accounts payable	$	34,244		$	36,618
Current account with Philips	2,757			4,240
Accrued payroll liabilities	10,898			15,070
Accrued warranty reserves	8,479			10,052
Deferred revenue	42,278			43,349
Income taxes payable	9,074			7,962
Accrued restructuring, reorganization and relocation	693			1,020
Other current liabilities	31,257			37,128
Total Current Liabilities	139,680			155,439
Convertible debt	225,000			295,000
Deferred tax liabilities	3,801			6,412
Other liabilities	4,831			5,373
Commitments and contingencies
Shareholders’ Equity:
Preferred stock - 500 shares authorized; none issued and outstanding	—			—
Common stock - 70,000 shares authorized; 33,653 and 33,413 shares issued and outstanding, no par value	318,769			315,632
Retained (deficit) earnings	(20,285		)	22,077
Accumulated other comprehensive income	16,369			41,861
Total Shareholders’ Equity	314,853			379,570
Total Liabilities and Shareholders’ Equity	$	688,165		$	841,794

See accompanying Condensed Notes to Consolidated Financial Statements.

2

FEI Company and Subsidiaries

Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

	For the Thirteen Weeks Ended						For the Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004			July 3, 2005			July 4, 2004
Net Sales:
Products	$	82,210		$	86,350		$	177,394		$	170,624
Products - related party	102			201			671			201
Service	24,909			21,709			49,905			42,197
Service - related party	272			208			516			540
Total net sales	107,493			108,468			228,486			213,562
Cost of Sales:
Products	52,840			49,569			106,314			98,969
Service	17,992			15,138			36,574			28,801
Total cost of sales	70,832			64,707			142,888			127,770
Gross Profit	36,661			43,761			85,598			85,792
Operating Expenses:
Research and development	15,867			13,131			32,054			26,698
Selling, general and administrative	25,174			22,764			50,487			42,878
Amortization of purchased technology	1,517			1,413			2,859			2,826
Asset impairment	15,944			—			15,944			—
Restructuring, reorganization and relocation	1,124			488			1,124			707
Total operating expenses	59,626			37,796			102,468			73,109
Operating (Loss) Income	(22,965		)	5,965			(16,870		)	12,683
Other Income (Expense):
Interest income	1,905			1,288			3,719			2,351
Interest expense	(3,982		)	(2,611		)	(6,489		)	(5,079		)
Other, net	(993		)	57			(1,209		)	(2,355		)
Total other expense, net	(3,070		)	(1,266		)	(3,979		)	(5,083		)
(Loss) income before income taxes	(26,035		)	4,699			(20,849		)	7,600
Income tax expense	19,750			1,645			21,513			2,660
Net (loss) income	$	(45,785	)	$	3,054		$	(42,362	)	$	4,940
Basic net (loss) income per share	$	(1.36	)	$	0.09		$	(1.26	)	$	0.15
Diluted net (loss) income per share	$	(1.36	)	$	0.08		$	(1.26	)	$	0.12
Shares used in per share calculations:
Basic	33,544			33,241			33,500			33,213
Diluted	33,544			39,734			33,500			39,724

See accompanying Condensed Notes to Consolidated Financial Statements.

3

FEI Company and Subsidiaries

Consolidated Statements of Comprehensive (Loss) Income

(In thousands)

(Unaudited)

	For the Thirteen Weeks Ended					For the Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004		July 3, 2005			July 4, 2004
Net (loss) income	$	(45,785	)	$	3,054	$	(42,362	)	$	4,940
Other comprehensive (loss) income:
Change in cumulative translation adjustment, zero taxes provided	(12,219		)	1,140		(20,557		)	(1,267		)
Change in unrealized loss on available-for-sale securities	(195		)	—		(591		)	—
Changes due to cash flow hedging instruments:
Net loss on hedge instruments	(3,737		)	—		(5,230		)	—
Reclassification to net income of previously deferred losses related to hedge derivatives instruments	1,245			—		886			—
Adjustment for fair value of derivatives	—			250		—			250
Comprehensive (loss) income	$	(60,691	)	$	4,444	$	(67,854	)	$	3,923

See accompanying Condensed Notes to Consolidated Financial Statements.

4

FEI Company and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

	For the Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004
Cash flows from operating activities:
Net (loss) income	$	(42,362	)	$	4,940
Adjustments to reconcile net (loss) income to net cash provided by (used by) operating activities:
Depreciation	8,194			7,570
Amortization	5,976			6,180
Asset impairments and write-offs	19,167			—
(Gain) loss on asset disposals	(942		)	124
Gain on non-monetary transactions	—			(636		)
Non-cash interest income from shareholder note receivable	—			(44		)
Premium on bond redemption	1,108			—
Deferred income taxes	16,700			714
Tax (reversal) benefit for non-qualified stock options exercised	(400		)	289
(Increase) decrease in:
Restricted cash	(1,382		)	(643		)
Receivables	36,148			(21,190		)
Current account with Accurel	515			182
Inventories	(20,358		)	8,855
Other assets	6,268			(5,329		)
Increase (decrease) in:
Accounts payable	1,125			(6,321		)
Current account with Philips	(583		)	(2,881		)
Accrued payroll liabilities	(3,010		)	371
Accrued warranty reserves	(611		)	(807		)
Deferred revenue	2,251			5,423
Income taxes payable	(4,717		)	(2,546		)
Accrued restructuring and reorganization costs	(337		)	(618		)
Other liabilities	(5,546		)	2,245
Net cash provided by (used by) operating activities	17,204			(4,122		)
Cash flows from investing activities:
Acquisition of property, plant and equipment	(9,065		)	(9,072		)
Proceeds from disposal of property, plant and equipment	3,021			—
Purchase of investments in marketable securities	(58,139		)	(43,905		)
Redemption of investments in marketable securities	81,107			31,477
Purchase of cost method investment	(580		)	—
Other	(34		)	(655		)
Net cash provided by (used by) investing activities	16,310			(22,155		)
Cash flows from financing activities:
Redemption of 5.5% convertible notes	(70,000		)	—
Proceeds from exercise of stock options and employee
stock purchases	3,537			1,296
Net cash (used by) provided by financing activities	(66,463		)	1,296
Effect of exchange rate changes	(8,737		)	1,753
Decrease in cash and cash equivalents	(41,686		)	(23,228		)
Cash and cash equivalents:
Beginning of period	114,326			97,430
End of period	$	72,640		$	74,202
Supplemental Cash Flow Information:
Cash paid for taxes	$	7,842		$	3,338
Cash paid for interest	6,599			3,988

See accompanying Condensed Notes to Consolidated Financial Statements.

5

FEI COMPANY AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.NATURE OF BUSINESS

We design, manufacture, market and service products and systems that are used in research, development and manufacturing of very small objects, primarily by providing an understanding of their three-dimensional shape. The majority of our customers work in fields that are classified as nanotechnology, which can be described as the science of characterizing, analyzing and fabricating things smaller than 100 nanometers (a nanometer is one billionth of a meter).

Our products are based largely on focused charged particle beam technology. Our products include transmission electron microscopes (“TEMs”), scanning electron microscopes (“SEMs”), focused ion-beam systems (“FIBs”), DualBeam systems that combine a FIB column and a SEM column on a single platform and software systems for computer aided design (“CAD”) navigation and yield management Our DualBeam systems include models that have wafer handling capability that are purchased by semiconductor manufacturers (“wafer-level DualBeams”) and models that have small stages and are sold to customers in several markets (“small stage DualBeams”). We also design, manufacture and sell some of the components of electron microscopes and FIBs to other manufacturers and provide service and support on our equipment. Our products are sold to a geographically diverse base of semiconductor manufacturers, thin film head manufacturers in the data storage industry and to industrial, institutional and research organizations in the life sciences and material sciences fields.

We have research, development and manufacturing operations in Hillsboro, Oregon; Peabody, Massachusetts; Sunnyvale, California; Mumbai, India; Eindhoven, the Netherlands; and Brno, Czech Republic.

Sales and service operations are conducted in the United States of America and 45 other countries around the world.  We also sell our products through independent agents and representatives in various additional countries.

2.BASIS OF PRESENTATION

The consolidated financial statements include the accounts of FEI Company and all of our wholly-owned subsidiaries (“FEI”). All significant intercompany balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements and condensed footnotes have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included.  The results of operations for the thirteen and twenty-six weeks ended July 3, 2005 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004, which was filed with the Securities and Exchange Commission (“SEC”) on March 14, 2005.

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period.  It is reasonably possible that the estimates we have made may change in the near future.Significant estimates underlying the accompanying consolidated financial statements include the allowance for doubtful accounts, reserves for excess or obsolete inventory, restructuring and reorganization costs, warranty liabilities, income tax related contingencies, tax valuation allowances, the valuation of businesses acquired and related in-process research and development and other intangibles, the lives and recoverability of equipment and

6

other long-lived assets such as existing technology intangibles, software development costs and goodwill and the timing of revenue recognition and stock-based compensation.

3.STOCK BASED COMPENSATION

We measure compensation expense for our stock-based employee compensation plans using the method prescribed by Accounting Principles Board Opinion No. 25 and its related interpretations, “Accounting for Stock Issued to Employees.” We provide disclosures of net (loss) income and net (loss) income per share as if the method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” had been applied in measuring compensation expense.

No compensation expense has been recognized for stock options granted at fair value on the date of grant or Employee Share Purchase Plan (“ESPP”) shares issued at a fifteen percent discount to the lower of the market price on either the first day of the applicable offering period or the purchase date.  Had compensation expense for our stock option plan and ESPP been determined based on the estimated fair value of the options or shares at the date of grant or issuance, our net income and net income per share would have been reduced to the amounts shown as follows (in thousands, except per share amounts):

	Thirteen Weeks Ended						Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004			July 3, 2005			July 4, 2004
Net (loss) income, as reported	$	(45,785	)	$	3,054		$	(42,362	)	$	4,940
Deduct - total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects	(5,073		)	(2,361		)	(7,974		)	(4,736		)
Net (loss) income, pro forma	$	(50,858	)	$	693		$	(50,336	)	$	204
Basic net (loss) income per share:
As reported	$	(1.36	)	$	0.09		$	(1.26	)	$	0.15
Pro forma	$	(1.52	)	$	0.02		$	(1.50	)	$	0.01
Diluted net (loss) income per share:
As reported	$	(1.36	)	$	0.08		$	(1.26	)	$	0.12
Pro forma	$	(1.52	)	$	0.02		$	(1.50	)	$	0.01

As discussed in Note 16, we did not record any tax benefit for United States losses generated in the thirteen and twenty-six week periods ended July 3, 2005.  Accordingly, the only tax benefit reflected in the pro forma stock-based employee compensation expense for such periods is for non-United States based awards.

The pro forma effects of applying SFAS No. 123 may not be representative of the effects on reported net (loss) income and net (loss) income per share for future periods since options vest over several years and additional awards are made each year.

To determine the fair value of stock-based awards granted, we used the Black-Scholes option pricing model and the following weighted average assumptions:

		Thirteen and Twenty-Six Weeks Ended
		July 3, 2005	July 4, 2004
Risk-free interest rate		2.8% - 4.3%	1.2% - 3.6%
Expected dividend yield		0%	0%
Expected lives	- option plans	5.5 years	5.73 – 5.80 years
	- ESPP	6 months	6 months
Expected volatility		73% - 74%	76% - 77%

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) finalized SFAS No. 123R, “Share-Based Payment,” which will be effective as of January 1, 2006. The new standard will require us to expense stock compensation costs related to our stock option and ESPP plans. The effect of expensing stock options on our results of operations should approximate the pro forma expense disclosed in the table above.

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4.RECLASSIFICATIONS

Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation. In particular, certain marketable securities recorded in cash and cash equivalents in the prior year, due to our ability to liquidate them within 90 days of purchase, have been reclassified to short-term investments due to our intent to liquidate these available-for-sale securities to meet short-term liquidity needs since their stated maturity is in excess of 90 days.

5.EARNINGS PER SHARE

Basic earnings per share (EPS) and diluted EPS are computed using the methods prescribed by SFAS No. 128, “Earnings per Share.”  Following is a reconciliation of the shares used for basic EPS and diluted EPS (in thousands):

	Thirteen Weeks Ended		Twenty-Six Weeks Ended
	July 3, 2005	July 4,  2004	July 3, 2005	July 4, 2004
Shares used for basic EPS	33,544	33,241	33,500	33,213
Dilutive effect of stock options calculated using the treasury stock method	—	964	—	982
Dilutive effect of convertible debt	—	5,529	—	5,529
Shares used for diluted EPS	33,544	39,734	33,500	39,724
Potential common shares excluded from diluted EPS since their effect would be antidilutive:
Stock options	3,345	1,989	3,343	1,765
Convertible debt	7,044	2,928	7,044	2,928

6.ASSET IMPAIRMENT CHARGES

In the second quarter of 2005, we initiated restructuring actions to align our cost structure with the current prevailing market conditions, primarily in the semiconductor markets.  The actions taken to date, which were necessary as a result of reduced business volumes, have resulted in decreases in our global workforce and also required us to evaluate our goodwill and long-lived assets for impairment in components of our microelectronics segment.

We recorded asset impairment charges and write-downs totaling $22.4 million in the thirteen and twenty-six week periods ended July 3, 2005 as either components of asset impairment or cost of sales on our consolidated statements of operations.  These charges are summarized as follows (in thousands):

	Asset Impairment		Cost of Sales		Total
Inventory	$	—	$	3,193	$	3,193
Purchased technology	9,328		—		9,328
Capitalized software	—		3,223		3,223
Property, plant and equipment	5,705		—		5,705
Patents and other intangibles	911		—		911
	$	15,944	$	6,416	$	22,360

Inventory

Write-downs of inventory pertain to lower of cost or market adjustments primarily for work in process and finished goods that, given the revisions to our forecasts, currently have no demand.  These tools have been written down to their estimated net realizable value.

Goodwill

We test goodwill annually in the fourth quarter, however, in the second quarter of 2005, based on our current and projected operating results, we concluded that there were sufficient indicators to require us to assess whether a portion of our recorded goodwill balance within our microelectronics segment was impaired at this

8

interim date. The impairment review was performed in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”  Based on this analysis, we concluded that the goodwill allocated to this segment was not impaired.

Long-Lived Assets

As a result of the initiation of our restructuring actions and due to the weakness in the semiconductor market, our projected future revenues and cash flows for certain asset groupings were revised downward in the second quarter of 2005. These factors led to indications that the carrying value of our long-lived assets, including purchased intangibles recorded in various acquisitions and property, plant and equipment, may not be recoverable and we performed an impairment review. The impairment review was performed in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  We evaluated the recoverability of the long-lived assets and concluded that impairments existed. Accordingly, we recorded impairment charges based on the amounts by which the carrying amounts of these assets exceeded their fair value.  Fair value was determined based on discounted cash flows for the operating entities that had separately identifiable cash flows. Impairment charges for long-lived assets totaled $16.5 million.  In addition, $2.6 million of capitalized software, patents and property, plant and equipment were written off as abandoned assets.

7.RESTRUCTURING, REORGANIZATION AND RELOCATION

As discussed in Note 6, we have initiated global restructuring activities to realign our cost structure with current prevailing market conditions.  These actions include reductions in workforce, reorganization and relocation of employees as well as closure of facilities.  Some of these actions were initiated in the second quarter of 2005 with the remainder continuing through the end of 2005.  These costs are accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  Under SFAS No. 146, liabilities for costs associated with exit or disposal activities are recognized and measured at fair value in the period the liability is incurred.

In the second quarter of 2005, we expensed and paid $0.9 million in severance and relocation costs related to workforce reductions and reallocation of personnel geographically, which is included as a component of restructuring, reorganization and relocation expense. The expected remaining costs are estimated to be approximately $15 million. $10.0 million of the charge is expected to be cash expenditures for severance, relocation and other employee related costs and will be paid through the remainder of 2005 and $5.0 million in facility closure charges are expected to be incurred in the second half of 2005 with cash expenditures expected to continue through the lease expiration dates ending in 2010.

Our restructuring accruals as of July 3, 2005 are for prior year restructuring activities and include $0.4 million related to our fourth quarter 2002 restructuring activities and $0.3 million related to the abandonment of a lease in the second quarter of 2004.  Our abandoned lease accruals were increased in the second quarter of 2005 by $0.2 million based on revisions in our estimated sublease benefits and is included as a component of restructuring, reorganization and relocation expense. The current estimate accrued for cash to be paid related to abandoned leases of $0.7 million is net of estimated sublease payments to be received and will be paid over the respective lease terms through 2006.

The following table summarizes the charges, expenditures and write-offs and adjustments in the twenty-six weeks ended July 3, 2005 related to our restructuring accruals (in thousands):

Twenty-Six Weeks Ended July 3, 2005	Beginning Accrued Liability		Charged to Expense		Expend- Itures			Write-Offs and Adjust- Ments			Ending Accrued Liability
Severance, outplacement and related benefits for terminated employees	$	150	$	924	$	(1,060	)	$	(14	)	$	—
Abandoned leases, leasehold improvements and facilities	870		200		(377		)	—			693
	$	1,020	$	1,124	$	(1,437	)	$	(14	)	$	693

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The restructuring charges are based on estimates that are subject to change.  Workforce related charges could change because of shifts in timing, redeployment or changes in amounts of severance and outplacement benefits.  Facilities charges could change due to changes in sublease income. Our ability to generate sublease income is dependent upon lease market conditions at the time we negotiate the sublease arrangements. Variances from these estimates could alter our ability to achieve anticipated expense reductions in the planned timeframe and modify our expected cash outflows and working capital.

8.DISPOSAL OF THE SIMS PRODUCT LINE

In the second quarter of 2005, we sold the net assets of our secondary ion mass spectrometer (“SIMS”) product line, which was part of our Electron Optics segment, for a net gain of $0.8 million, which was recorded as a component of selling, general and administrative expenses.  Proceeds from the sale totaled $2.5 million in cash and $2.5 million in a note receivable due in January 2006, which is secured by a bank guarantee. The purchase price is subject to adjustment based on a final net asset audit, and, accordingly, we have deferred recognizing a portion of the gain totaling $0.3 million until the contingency is resolved.  Net assets disposed and the related selling costs totaled $4.0 million.  Revenues for this product line totaled $3.0 million and $4.0 million, respectively, for the twenty-six weeks ended July 3, 2005 and July 4, 2004.

9.BANK GUARANTEES AND RESTRICTED CASH

At July 3, 2005 and December 31, 2004, we had outstanding standby letters of credit and bank guarantees totaling approximately $29.0 million and $24.7 million, respectively.  Restricted cash related to these letters of credit and bank guarantees totaled $20.0 million and $20.5 million at July 3, 2005 and December 31, 2004, respectively. For guarantees that expire within twelve months of the balance sheet dates, the associated restricted cash is recorded as a current asset.

10.FACTORING OF ACCOUNTS RECEIVABLE

In the second quarter of 2005 and 2004, we entered into agreements under which we sold $1.3 million and $5.2 million, respectively, of our accounts receivable at a discount to unrelated third party financiers without recourse. The transfers qualify for sales treatment under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Discounts related to the sale of the receivables, which were immaterial in the second quarter of 2005 and 2004, are recorded in our statement of operations as other expense.

11.INVENTORIES

Inventories are stated at the lower of cost or market, with cost determined by standard cost methods, which approximate the first-in, first-out method. Inventory costs include material, labor and manufacturing overhead. Service inventories that exceed the estimated requirements for the next twelve months based on recent usage levels are reported as other long-term assets.

Inventories consisted of the following (in thousands):

	July 3, 2005		December 31, 2004
Raw materials and assembled parts	$	29,953	$	26,687
Service inventories, estimated current requirements	11,657		11,763
Work-in-process	43,409		31,140
Finished goods	6,957		18,193
Total inventories	$	91,976	$	87,783
Service inventories included in other long-term assets	$	32,530	$	33,748

10

We periodically review inventory for obsolete or slow moving items and make adjustments, as required.  Production inventory charges for the thirteen and twenty-six weeks ended July 3, 2005 totaled $3.2 million related to the restructuring activities discussed in Note 6.  Ongoing charges for the periods were insignificant.  Service inventory charges were $0.5 million and $1.0 million, respectively, for the thirteen and twenty-six weeks ended July 3, 2005, and were recorded as a component of cost of sales.

12.GOODWILL, PURCHASED TECHNOLOGY AND OTHER INTANGIBLE ASSETS

Goodwill

The roll-forward of our goodwill is as follows (in thousands):

	Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004
Balance, beginning of period	$	41,486		$	41,423
Adjustments to goodwill	(25		)	10
Balance, end of period	$	41,461		$	41,433

See Note 6 above for a discussion of the goodwill analysis performed in the second quarter of 2005.

Adjustments to goodwill include translation adjustments resulting from a portion of our goodwill being recorded on the books of our foreign subsidiaries.

Purchased Technology and Other Intangible Assets

At July 3, 2005 and December 31, 2004, our other intangible assets included purchased technology, capitalized software and patents, trademarks and other intangible assets.  The gross amount of our other intangible assets and the related accumulated amortization were as follows (in thousands):

	Amortization Period	July 3, 2005			December 31, 2004
Purchased technology	5 to 12 years	$	48,608		$	48,951
Accumulated amortization		(39,005		)	(26,871		)
		$	9,603		$	22,080
Capitalized software	3 years	$	11,628		$	15,395
Accumulated amortization		(11,204		)	(9,745		)
		424			5,650
Patents, trademarks and other	2 to 15 years	5,378			5,308
Accumulated amortization		(2,571		)	(1,340		)
		2,807			3,968
Note issuance costs	5 to 7 years	10,732			10,732
Accumulated amortization		(6,689		)	(4,799		)
		4,043			5,933
Total intangible assets included in other long-term assets		$	7,274		$	15,551

See Note 6 above for a discussion of impairment charges and write-offs related to purchased software, capitalized software and patents recognized during the second quarter of 2005.

See also Note 14 for a discussion of note issuance cost write-offs totaling $1.1 million related to the convertible note redemptions in the second quarter of 2005.

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Amortization expense, excluding impairment charges and note issuance cost write-offs, was as follows (in thousands):

	Twenty-Six Weeks Ended
	July 3, 2005		July 4, 2004
Purchased technology	$	2,859	$	2,826
Capitalized software	1,801		2,113
Patents, trademarks and other	350		415
Note issuance costs	791		826
	$	5,801	$	6,180

Amortization is as follows over the next five years and thereafter (in thousands):

	Purchased Technology		Capitalized Software		Patents, Trademarks and Other		Note Issuance Costs
Remainder of 2005	$	1,357	$	71	$	357	$	664
2006	2,494		141		603		1,327
2007	2,125		141		515		1,327
2008	2,125		71		222		725
2009	980		—		171		—
Thereafter	522		—		939		—
	$	9,603	$	424	$	2,807	$	4,043

13.INVESTMENTS

On May 6, 2005, we purchased an additional $0.6 million of convertible notes maturing on April 7, 2007 from a company in which we held a 19.9% equity interest, totaling $1.0 million, and convertible notes totaling $2.5 million, prior to the $0.6 million purchase. We have also committed to purchase up to an additional $2.2 million of convertible notes from this company over the next several months, contingent on this company meeting certain product development milestones.

In July 2005, we purchased an additional $0.6 million of convertible notes pursuant to the aforementioned purchase agreement, leaving a $1.6 million potential future investment

Also in July 2005, we purchased $1.4 million of preferred shares from a company in which we held debt and equity interests totaling $2.5 million prior to the July 2005 investment. Our equity interest in this company is 17.8% after the purchase of the preferred shares.  Pursuant to this agreement, we, as part of a consortium of investors, have also agreed to acquire an additional $0.7 million of preferred shares and convertible debt in the event the company cannot obtain outside financing on or before December 31, 2005.

During the thirteen and twenty-six week periods ended July 3, 2005, we recorded a charge of $0.8 million as a component of other income (expense) related to the write-down of one of our cost method investments for which we concluded an other-than-temporary impairment existed.

14.5.5% CONVERTIBLE SUBORDINATED NOTE REDEMPTION

In the second quarter of 2005, we redeemed $70.0 million of our 5.5% convertible subordinated notes at a redemption price of 101%. The premium and commissions paid on the redemption totaled $0.7 million and were expensed in the second quarter of 2005 as a component of interest expense. Additionally, related deferred note issuance costs of $1.1 million were expensed in the second quarter of 2005 as a component of interest expense.

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15.WARRANTY RESERVES

Our products generally carry a one-year warranty. A reserve is established at the time of sale to cover estimated warranty costs as a component of cost of sales on our consolidated statements of operations. Our estimate of warranty cost is based on our history of warranty repairs and maintenance. While most new products are extensions of existing technology, the estimate could change if new products require a significantly different level of repair and maintenance than similar products have required in the past. Our estimated warranty costs are reviewed and updated on a quarterly basis. Historically, these reviews have not resulted in material adjustments to previous estimates.

The following is a summary of warranty reserve activity (in thousands):

	Twenty-Six Weeks Ended
	July 3, 2005			July 4, 2004
Balance, beginning of period	$	10,052		$	10,500
Reductions for warranty costs incurred	(6,419		)	(5,834		)
Warranties issued	5,582			5,035
Translation and other items	(736		)	(113		)
Balance, end of period	$	8,479		$	9,588

16.INCOME TAXES

Net deferred tax assets are as follows (in thousands):

	July 3, 2005			December 31, 2004
Deferred tax assets:
Current	$	9,021		$	8,365
Non-current	29,311			23,411
Gross deferred tax assets	38,332			31,776
Valuation allowance	(30,885		)	(4,856		)
Deferred tax assets, net of valuation allowance	7,447			26,920
Deferred tax liabilities:
Current	(599		)	(1,493		)
Non-current	(3,801		)	(6,412		)
Total deferred tax liabilities	(4,400		)	(7,905		)
Net deferred tax assets	$	3,047		$	19,015

We recorded a tax provision expense of approximately $19.8 million and $21.5 million, respectively, for the thirteen and twenty-six week periods ended July 3, 2005. The provisions do not reflect a benefit for current period losses in the United States as we have recorded a full valuation allowance against the United States deferred tax assets generated from the current period losses. Of the $19.8 million tax provision in the thirteen weeks ended July 3, 2005, $14.3 million was to record a valuation allowance for our existing United States deferred tax assets.  Valuation allowances on deferred tax assets totaled $30.9 million and $4.9 million as of July 3, 2005 and December 31, 2004, respectively.

In assessing the realizability of deferred tax assets, SFAS No. 109, “Accounting for Income Taxes,” establishes a more likely than not standard. If it is determined that it is more likely than not that deferred tax assets will not be realized, a valuation allowance must be established against the deferred tax assets. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.

Although we anticipate future sustained profitability, SFAS No. 109 requires that recent historical operating performance and income projections be considered in assessing the realizability of the deferred tax assets.

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The more likely than not assessment was principally based upon our historical losses, the impact of the restructuring activities discussed in Notes 6 and 7 and our forecast of future profitability in certain tax jurisdictions.

At July 3, 2005, we had approximately $55.3 million of net operating loss carryforwards to offset future United States taxable income, expiring from 2023 through 2025 and $27.4 million for Oregon state tax purposes, expiring through 2020. We placed a full valuation allowance against the tax effect of all United States net operating and capital loss carryforwards.

17.RELATED PARTY ACTIVITY

Philips

Philips Business Electronics International B.V. (“Philips”), a subsidiary ofKoninklijke Philips Electronics NV, currently owns approximately 25% of our common stock.  For sales to Philips, see “Sales to Related Parties” below.  The following table summarizes our other transactions with Philips (in thousands):

	Thirteen Weeks Ended				Twenty-Six Weeks Ended
Amounts Paid to Philips	July 3, 2005		July 4, 2004		July 3, 2005		July 4, 2004
Subassemblies and other materials purchased from Philips	$	5,910	$	4,570	$	9,453	$	6,480
Facilities leased from Philips	59		47		141		90
Various administrative, accounting, customs, export, human resources, import, information technology, logistics and other services provided by Philips	181		124		416		242
Research and development services provided by Philips	1,308		1,125		1,764		2,333
	$	7,458	$	5,866	$	11,774	$	9,145

Current accounts with Philips represent accounts receivable and accounts payable between us and other Philips units. Most of the current account transactions relate to deliveries of goods, materials and services.  Current accounts with Philips consisted of the following (in thousands):

	July 3, 2005			December 31, 2004
Current accounts receivable	$	242		$	276
Current accounts payable	(2,999		)	(4,516		)
Net current accounts with Philips	$	(2,757	)	$	(4,240	)

Accurel

Mr. Sarkissian, our Chief Executive Officer, President and Chairman of our Board of Directors, owned a 50% interest in Accurel Systems International Corp. (“Accurel”), an analytical services provider to the semiconductor and data storage markets. We have sold equipment and related services and have provided certain other services to Accurel. In March 2005, Accurel was sold to Implant Sciences Corporation, an unrelated third party.  Following the sale, Mr. Sarkissian owns less than 5% of the outstanding stock of Implant Sciences Corporation.

In March 2005, Implant Sciences Corporation paid us the $1.2 million that Accurel owed us for a system they purchased in 2002. Subsequent to the acquisition date, neither Implant Sciences Corporation nor Accurel is considered a related party.

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Sales to Related Parties

In addition to Philips, we have sold products and services to LSI Logic Corporation, Applied Materials and Nanosys. A director of Applied Materials, the Chairman and Chief Executive Officer of LSI Logic and the Executive Chairman of Nanosys are all members of our Board of Directors.  Related party sales to Philips, Accurel (prior to being acquired), Applied Materials, LSI Logic and Nanosys, were as follows (in thousands):

	Thirteen Weeks Ended					Twenty-Six Weeks Ended
	July 3, 2005		July 4, 2004			July 3, 2005		July 4, 2004
Product sales:
Philips	$	102	$	201		$	228	$	201
Applied Materials	—		—			439		—
LSI Logic	—		—			4		—
Total product sales	102		201			671		201
Service sales:
Philips	$	149	$	(5	)	$	186	$	(5	)
Accurel	—		105			151		338
Applied Materials	70		—			108		—
LSI Logic	48		108			64		207
Nanosys	5		—			7		—
Total service sales	272		208			516		540
Total sales to related parties	$	374	$	409		$	1,187	$	741

18.COMMITMENTS AND CONTINGENCIES

From time to time, we may be a party to litigation arising in the ordinary course of business.  Currently, we are not a party to any litigation that we believe would have a material adverse effect on our financial position, results of operations or cash flows.

We are self-insured for certain aspects of our property and liability insurance programs and are responsible for deductible amounts under most policies. The deductible amounts generally range from $10,000 to $350,000 per claim.  Our director and officer liability insurance coverage, however, has a $3.0 million deductible relating to entity coverage.

We participate in third party equipment lease financing programs with U.S. financial institutions for a small portion of products sold. In these circumstances, the financial institution purchases our equipment and then leases it to a third party. Under these arrangements, the financial institutions have limited recourse against us on a portion of the outstanding lease portfolio if the lessee defaults on the lease.  We did not add to such guarantees during the thirteen weeks ended July 3, 2005, and, as of July 3, 2005, we had outstanding guarantees totaling $2.8 million related to these lease transactions. Under certain circumstances, we are obligated to exercise best efforts to re-market the equipment should the financial institutions reacquire it.  As of July 3, 2005, we did not have any guarantees that require us to re-market the equipment.

We have commitments under non-cancelable purchase orders, primarily relating to inventory, totaling $27 million at July 3, 2005.  These commitments expire at various times through December 2005.

As discussed in Note 13, we have committed to invest an additional $1.6 million and $0.7 million, respectively, in two non-public companies in which we have equity interests, subject to certain contingencies being met.

19.SEGMENT INFORMATION

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Operating Review Board, which consists of our Chief Operating Officer, our Chief Financial Officer, our Senior Vice Presidents and other senior management. We operate in four business segments: microelectronics,

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electron optics, components and service. The microelectronics segment manufactures and markets FIBs and DualBeam systems. Microelectronics segment products are sold primarily to the semiconductor and data storage markets, with additional sales to the industry and institute market. The electron optics segment manufactures and markets SEMs and TEMs. Electron optics products are sold to materials and life sciences customers in the industry and institute markets, as well as in the semiconductor and data storage markets. The components segment manufactures and markets electron and ion emitters, focusing columns and components thereof. These components are used in our FIB, DualBeam, SEM and TEM systems and also are sold to other equipment manufacturers. The service segment supports our worldwide installed base of products, generally under service contracts.

The following table summarizes various financial amounts for each of our business segments (in thousands):

Thirteen Weeks Ended July 3, 2005	Microelectronics			Electron Optics			Components			Service		Corporate and Eliminations			Total
Sales to external customers	$	45,969		$	34,656		$	1,687		$	25,181	$	—		$	107,493
Inter-segment sales	290			3,122			1,320			857		(5,589		)	—
Total sales	46,259			37,778			3,007			26,038		(5,589		)	107,493
Operating (loss) income	(19,013		)	(2,256		)	(326		)	3,180		(4,550		)	(22,965		)
Thirteen Weeks Ended July 4, 2004
Sales to external customers	$	54,410		$	29,478		$	2,663		$	21,917	$	—		$	108,468
Inter-segment sales	553			3,680			1,405			862		(6,500		)	—
Total sales	54,963			33,158			4,068			22,779		(6,500		)	108,468
Operating income (loss)	7,814			(3,115		)	118			3,443		(2,295		)	5,965
Twenty-Six Weeks Ended July 3, 2005	Microelectronics			Electron Optics			Components			Service		Corporate and Eliminations			Total
Sales to external customers	$	103,634		$	70,784		$	3,647		$	50,421	$	—		$	228,486
Inter-segment sales	661			7,653			2,920			1,618		(12,852		)	—
Total sales	104,295			78,437			6,567			52,039		(12,852		)	228,486
Operating (loss) income	(11,871		)	(3,324		)	(386		)	6,308		(7,597		)	(16,870		)
Twenty-Six Weeks Ended July 4, 2004
Sales to external customers	$	96,763		$	68,779		$	5,615		$	42,405	$	—		$	213,562
Inter-segment sales	929			3,833			2,907			1,215		(8,884		)	—
Total sales	97,692			72,612			8,522			43,620		(8,884		)	213,562
Operating income (loss)	11,154			(1,796		)	623			7,631		(4,929		)	12,683
July 3, 2005	Microelectronics			Electron Optics			Components			Service		Corporate and Eliminations			Total
Total assets	$	149,217		$	118,940		$	16,449		$	84,594	$	318,965		$	688,165
December 31, 2004
Total assets	$	192,659		$	138,564		$	17,738		$	93,118	$	399,715		$	841,794

Inter-segment sales are shown at cost, with no markup for gross profit within the selling segment, and are eliminated in consolidation. Corporate administration expenses, charges for in-process research and development, merger costs, and restructuring and reorganization costs are not allocated to our business segments.  Certain costs were reclassified in the prior period to conform to current period allocations. See our Consolidated Statements of Operations for reconciliations from operating income to income before income taxes. These reconciling items are not included in the measure of profit and loss for each reportable segment.

On July 11, 2005, we announced that we were reorganizing into three primary end markets: Nanoelectronics, Nanoresearch and Nanobiology.  As a result, we plan to realign and restate our segment reporting beginning in 2006, after all the structural changes are complete.

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None of our customers represented 10% or more of our total sales in the thirteen and twenty-six week periods ended July 3, 2005 or July 4, 2004.

20.NEW ACCOUNTING PRONOUNCEMENTS

SFAS No. 154

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3”, which requires companies to apply most voluntary accounting changes retrospectively to prior financial statements.  SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Any future voluntary accounting changes made by us will be accounted for under SFAS No. 154 and will be applied retrospectively.

SFAS No. 153

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets.”  SFAS No. 153 amends APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” by replacing the exception for exchanges of similar productive assets with an exception for exchanges that do not have commercial substance.  A transaction has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.  SFAS No. 153 is effective for fiscal periods beginning after June 15, 2005.  We do not expect the adoption of SFAS No. 153 to have any effect on our financial position, results of operations or cash flow.

FSP No. 109-2

In December, 2004, the FASB issued FASB Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisions within the American Jobs Creation Act of 2004” (the Jobs Act). FSP No. 109-2 provides guidance with respect to reporting the potential impact of the repatriation provisions of the Jobs Act on an enterprise’s income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004, and provides for a temporary 85% dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction would result in an approximate 5.25% federal tax rate on the repatriated earnings. To qualify for the deduction, the earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by a company’s chief executive officer and approved by a company’s board of directors. Certain other criteria in the Jobs Act must be satisfied as well. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings. We have completed our initial evaluation of the impact of the repatriation provisions of the Jobs Act, and have estimated the range of potential dividends from our foreign entities could be $0 to $62 million; however, the impact of this potential dividend repatriation on our tax position is dependent upon the resolution of factors surrounding our usage of our United States net operating losses. Accordingly, as provided for in FSP No. 109-2, we have not adjusted our tax expense or deferred tax liability to reflect the repatriation provisions of the Jobs Act.

SFAS No. 123(R)

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” which requires companies to recognize in their income statement the grant-date fair value of stock options and other equity-based compensation issued to employees.  SFAS No. 123(R) is effective for annual periods beginning after June 15, 2005. Accordingly, we expect to adopt SFAS No. 123(R) in our first quarter of 2006. See Note 3 Stock-Based Compensation above for the pro forma effects of how SFAS No. 123 would have affected results of operations in the thirteen and twenty-six weeks ended July 3, 2005 and July 4, 2004.  SFAS No. 123(R) will not have any effect on our cash flows.

SFAS No. 151

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs: an amendment of ARB No. 43, Chapter 4,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material.  SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  While we have not completed our analysis of the impact of SFAS No. 151, we do not currently believe the provisions of SFAS No. 151, when applied, will have a material impact on our financial position, results of

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operations or cash flows.

21.AMENDMENTS TO STOCK PLANS

At our Annual Meeting of Shareholders, which was held on May 19, 2005, our shareholders approved an amendment to our 1995 Stock Incentive Plan to increase the number of shares of our common stock reserved for issuance under the plan from 7,000,000 to 8,000,000. In addition, the shareholders approved an amendment to our Employee Share Purchase Plan to increase the number of shares of our common stock reserved for issuance under the plan from 1,450,000 to 1,950,000.

22.SUBSEQUENT EVENT

Preferred Stock Rights Plan

On July 21, 2005, we adopted a Preferred Stock Rights Plan (the “Plan”).  Pursuant to the Plan, rights will be distributed as a dividend at the rate of one right for each share of our common stock held by stockholders of record as of the close of business on August 12^th, 2005. The rights expire on August 12, 2015, unless redeemed or exchanged. Under the Plan, each right entitles a registered holder to buy one one-thousandth share of preferred stock for $120, subject to adjustment. The rights will become exercisable only if a person or group (other than stockholders currently owning 20% of our common stock) acquires beneficial ownership of 20% or more of our common stock, or commences a tender offer or exchange offer upon consummation of which such person or group would beneficially own 20% or more of our common stock.  Philips Business Electronics International B.V., or any of its affiliates, shall not be considered for the 20% calculation so long as it does not acquire 30% or more of the common shares.

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This document contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include any projections of earnings, revenues, or other financial items; any statements of the plans, strategies, and objectives of management for future operations and expenditures; factors affecting our 2005 operating results; any statements concerning proposed new products, services, developments, impairments, restructuring charges and changes to our restructuring reserves, or anticipated performance of products or services; any statements regarding planned capital expenditures; any statements regarding adoption of new accounting standards; any statements regarding future economic conditions or performance; any statements regarding timing for shipping our new products; any statements of belief; and any statements of assumptions underlying any of the foregoing. You can identify these statements by the fact that they do not relate strictly to historical or current facts and use words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” and other words and terms of similar meaning. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public.

The risks, uncertainties and assumptions referred to above include, but are not limited to, those discussed here and the risks discussed from time to time in our other public filings. All forward-looking statements included in this document are based on information available to us as of the date of this report, and we assume no obligation to update these forward-looking statements. You are advised, however, to consult any further disclosures we make on related subjects in our Forms 10-K, 10-Q and 8-K filed with, or furnished to, the SEC. We provide a cautionary discussion of risks and uncertainties relevant to our businesses under the section titled “Cautionary Factors that May Affect Future Results.” These items are factors that we believe could cause our actual results to differ materially from expected and historical results. Other factors also could adversely affect us.

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Summary of Products and Segments

We are a leading supplier of products that enable the research, development and manufacturing of nanoscale features by helping our customers understand their three-dimensional structures. We serve the semiconductor, data storage and industry and institute markets where decreasing feature sizes and the need for sub-surface, structural information drive the need for our equipment and services. Our products and systems include hardware and software for focused ion beams, or FIBs, scanning electron microscopes, or SEMs, transmission electron microscopes, or TEMs, and DualBeam systems, which combine a FIB and SEM on a single platform, as well as CAD navigation and yield management software. TEMs and SEMs comprise our electron optics segment products. DualBeams, FIBs and CAD navigation and yield management software products collectively comprise our microelectronics segment products.

Our DualBeam systems include models that have wafer handling capability that are purchased by semiconductor manufacturers (“wafer-level DualBeams”) and models that have small stages and are sold to customers in several markets (“small stage DualBeams”). We recently introduced a new ultra-high resolution TEM, the Titan.

Overview

Our consolidated bookings declined in the second quarter of 2005 compared with both the second quarter of 2004 and the first quarter of 2005.  Net sales were also down from the first quarter of 2005 and the second quarter of 2004.  We recorded a significant net loss in the latest quarter, primarily due to a series of write-offs and impairment charges related to weakness in the semiconductor market and our decision to consolidate operations and close our Peabody, Massachusetts facility.

Our financial results for the thirteen and twenty-six weeks ended July 3, 2005 included the following:

•a gain of $0.8 million from the sale of our secondary ion mass spectrometer product line, included in selling, general and administrative expense;

•a charge of $1.8 million related to the repurchase and retirement of $70 million face value of our 5.5% convertible notes, included in interest expense;

•charges for the write-down of inventory and capitalized software of $6.4 million, included in cost of goods sold;

•charges for restructuring, reorganization and relocation expenses totaling $1.1 million, as well as impairment of certain fixed, intangible and other assets, related primarily to parts of our semiconductor business, totaling $15.9 million, each included as a separate line item on our consolidated statements of operations;

•a charge of $0.8 million for an impairment in the carrying value of an investment in a non-public company; and

•A charge of $14.3 million due to a re-evaluation of our deferred tax assets, included in income tax expense.

Combined, these charges totaled $39.5 million.

Most of the weakness in customer demand in the second quarter of 2005 was concentrated in the semiconductor market, where bookings were down 51% compared with the second quarter of 2004 and 33% from the first quarter of 2005.  The weakness appears to be broad, as several large orders that had been expected in the quarter were deferred by customers.  In contrast, bookings from the smaller data storage market increased significantly from first-quarter levels and were approximately equal to the second quarter 2004 level, which was the strongest quarter of last year. The data storage industry’s transition to new perpendicular recording technology is contributing to increased demand for our products. Bookings from the industry and institute market were up 48% from the second quarter of 2004 and down 2% from the first quarter of 2005, aided by continued government funding of nanotechnology research and successful new product introductions.

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By product, the year-over-year bookings growth continued to come from our transmission electron microscopes, propelled by initial bookings for our new line of ultra-high resolution scanning transmission electron microscopes (“(S)TEM”).  Shipments of this line of microscopes are scheduled to begin later in 2005.

Gross margins decreased from the second quarter of last year and the first quarter of 2005.  This change was due to lower shipment volume, lower shipments of higher margin semiconductor related products, less favorable product mix, capitalized software write-offs and inventory write-offs related to our restructuring. The stronger United States dollar in the second quarter of 2005 compared to the first quarter of 2005 had a positive impact on our cost of sales and operating expenses, but losses from our hedging program offset most of those gains in the second quarter.

We anticipate that our operating results in coming quarters will continue to be affected somewhat by volatility in exchange rates. However, with our hedging program, we are better able to match realized gains and losses pertaining to these derivative contracts with the actual economic gains and losses of the underlying hedge transaction in the appropriate line items of our statement of operations.  See also Item 3. Quantitative and Qualitative Disclosures about Market Risk below.

Outlook for the Remainder of 2005

For the remainder of 2005, we expect our revenues to continue to be substantially dependent upon the health of the semiconductor market, and to a lesser extent, data storage and industry and institute markets. Demand from the semiconductor industry is expected to remain soft. Demand from the data storage market, while volatile from quarter to quarter, is expected to generally follow a positive trend. However, we expect lower third quarter 2005 revenue compared to prior quarters, with the increases following in the fourth quarter of 2005. Demand from industry and institute customers remains strong, but an increasing portion of those orders are scheduled for delivery later in 2005 and in 2006. As a result of this combination of factors, net sales in the third quarter of 2005 are expected to be flat to down slightly compared to the second quarter 2005 levels.  We do expect a sequential increase in net sales in the fourth quarter of 2005.  Over the longer term, we believe we will have ongoing opportunities for growth in all our markets due to the increasing demand for nano-scale information across a range of industries.

We expect to record net losses in the third quarter of 2005 as a result of further restructuring charges due to the consolidation of operations and a reduction in employee headcount.

We expect our foreign currency hedging activities to partially mitigate the effects of foreign currency exchange fluctuations on our gross margins in 2005, although these fluctuations will continue to have some impact on our financial results.  If the euro/dollar exchange rate remains at the levels of the end of the second quarter of 2005, we will see a positive operating benefit in the second half of 2005.  That benefit will be partially offset by the costs of our hedging program.

Critical Accounting Policies and the Use of Estimates

We have no changes or updates to the critical accounting policies and estimates reported in our Annual Report on Form 10-K for the year ended December 31, 2004, which was filed with the SEC on March 14, 2005.

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Results of Operations

The following table sets forth our statement of operations data, both in absolute dollars and as a percentage of net sales (dollars in thousands).

	Thirteen Weeks Ended(1) July 3, 2005					Thirteen Weeks Ended(1) July 4, 2004
Net sales	$	107,493		100.0	%	$	108,468		100.0	%
Cost of sales	70,832			65.9		64,707			59.7
Gross profit	36,661			34.1		43,761			40.3
Research and development	15,867			14.8		13,131			12.1
Selling, general and administrative	25,174			23.4		22,764			21.0
Amortization of purchased technology	1,517			1.4		1,413			1.3
Asset impairment	15,944			14.8		—			—
Restructuring, reorganization and relocation	1,124			1.0		488			0.4
Operating (loss) income	(22,965		)	(21.4	)	5,965			5.5
Other expense, net	(3,070		)	(2.9	)	(1,266		)	(1.2	)
(Loss) income before income taxes	(26,035		)	(24.2	)	4,699			4.3
Income tax expense	19,750			18.4		1,645			1.5
Net (loss) income	$	(45,785	)	(42.6	)%	$	3,054		2.8	%

	Twenty-Six Weeks Ended(1) July 3, 2005					Twenty-Six Weeks Ended(1) July 4, 2004
Net sales	$	228,486		100.0	%	$	213,562		100.0	%
Cost of sales	142,888			62.5		127,770			59.8
Gross profit	85,598			37.5		85,792			40.2
Research and development	32,054			14.0		26,698			12.5
Selling, general and administrative	50,487			22.1		42,878			20.1
Amortization of purchased technology	2,859			1.3		2,826			1.3
Asset impairment	15,944			7.0		—			—
Restructuring, reorganization and relocation	1,124			0.5		707			0.3
Operating (loss) income	(16,870		)	(7.4	)	12,683			5.9
Other expense, net	(3,979		)	(1.7	)	(5,083		)	2.4
(Loss) income before income taxes	(20,849		)	(9.1	)	7,600			3.6
Income tax expense	21,513			9.4		2,660			1.2
Net (loss) income	$	(42,362	)	(18.5	)%	$	4,940		2.3	%

(1)  Percentages may not add due to rounding.

Net sales decreased $1.0 million, or 0.9%, to $107.5 million, in the thirteen weeks ended July 3, 2005 (the second quarter of 2005) compared to $108.5 million in the thirteen weeks ended July 4, 2004 (the second quarter of 2004).  Net sales increased $14.9 million, or 7.0%, to $228.5 million in the twenty-six week period ended July 3, 2005 compared to $213.6 million in the twenty-six week period ended July 4, 2004. The increases in net sales are discussed in more detail below.

Net Sales by Segment

Net sales include sales in our microelectronics, electron optics, components and service segments.  Sales by segment (in thousands) and as a percentage of total sales were as follows:

	Thirteen Weeks Ended
	July 3, 2005				July 4, 2004
Microelectronics	$	45,969	42.8	%	$	54,410	50.2	%
Electron Optics	34,656		32.2	%	29,478		27.2	%
Service	25,181		23.4	%	21,917		20.2	%
Components	1,687		1.6	%	2,663		2.4	%
	$	107,493	100.0	%	$	108,468	100.0	%

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	Twenty-Six Weeks Ended
	July 3, 2005				July 4, 2004
Microelectronics	$	103,634	45.3	%	$	96,763	45.3	%
Electron Optics	70,784		31.0	%	68,779		32.2	%
Service	50,421		22.1	%	42,405		19.9	%
Components	3,647		1.6	%	5,615		2.6	%
	$	228,486	100.0	%	$	213,562	100.0	%

Microelectronics

Sales in the microelectronics segment decreased $8.4 million, or 15.5%, and increased $6.9 million, or 7.1%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. The decrease in the thirteen week period ended July 3, 2005 compared to the same period of 2004 was due to the weakness in the semiconductor equipment market in the second quarter of 2005.

For the twenty-six week period ended July 3, 2005 compared to the same period of 2004, the weakness in the semiconductor market in the second quarter of 2005 was offset by strong semiconductor equipment sales from our backlog in the first quarter of 2005, primarily our wafer-level DualBeam systems, and increased sales of our small stage DualBeam products, especially our newer products that were introduced subsequent to the first quarter of 2004. Sales of our wafer-level DualBeam systems also increased in the twenty-six weeks ended July 3, 2005 compared to the same period of 2004.  These increases were partially offset by a decline in sales of our mask repair tools.

Electron Optics

Sales in the electron optics segment increased $5.2 million, or 17.6%, and $2.0 million, or 2.9%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004.  The increases were primarily due to increased demand for our high resolution TEM products.  We anticipate that we will begin shipping a new ultra-high resolution TEM product in the third quarter of 2005, for which we already have a backlog of orders.

Service

Sales in the service segment increased $3.3 million, or 14.9%, and $8.0 million, or 18.9%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004, primarily due to continued expansion of our installed base.  Service sales are driven by the size of our installed base and the percentage of our installed base that is more than one year old, as our warranty period is typically one year.  Increased sales of systems that have reached the end of their warranty periods usually lead to a related increase in service contracts.

Components

Sales in the components segment decreased $1.0 million, or 36.7%, and $2.0 million, or 35.0%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. These decreases were primarily due to declines in the refurbishment business as a result of higher quality, longer lasting products.  Certain of our component sales include equipment refurbishment.

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Sales by Geographic Region

A significant portion of our revenue has been derived from customers outside of the United States, and we expect this to continue.  The following table shows our net sales by geographic location (dollars in thousands):

	Thirteen Weeks Ended								Twenty-Six Weeks Ended
	July 3, 2005				July 4, 2004				July 3, 2005				July 4, 2004
North America	$	33,812	31.4	%	$	46,938	43.3	%	$	67,470	29.5	%	$	87,290	40.9	%
Europe	47,358		44.1	%	24,693		22.7	%	92,594		40.5	%	61,051		28.6	%
Asia-Pacific Region	26,323		24.5	%	36,837		34.0	%	68,422		30.0	%	65,221		30.5	%
	$	107,493	100.0	%	$	108,468	100.0	%	$	228,486	100.0	%	$	213,562	100.0	%

North America

Sales in North America decreased $13.1 million, or 28.0%, and $19.8 million, or 22.7%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. These decreases were primarily due to softness in the semiconductor industry and timing of government funding in the industry and institute market.  Although we expect bookings to improve in future quarters, we expect revenue trends to be flat in the third quarter of 2005 compared to the second quarter of 2005.

Europe

Sales in Europe increased $22.7 million, or 91.8%, and $31.5 million, or 51.7%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. These increases were primarily due to strength in sales of our small stage DualBeam products, chiefly those that were introduced subsequent to the first quarter of 2004, and the sale of more wafer-level DualBeam systems in the 2005 periods compared to the 2004 periods.  We also had improvements in our Certus data storage networking tool and TEM sales in the 2005 periods compared to the 2004 periods.

Asia-Pacific Region

Sales in the Asia-Pacific Region decreased $10.5 million, or 28.5%, and increased $3.2 million, or 4.9%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. The decrease in the thirteen weeks ended July 3, 2005 compared to the same period of 2004 was due to weakness in the semiconductor markets in both Japan and Korea. The increase in the twenty-six week period ended July 3, 2005 compared to the same period of 2004 was due to strength in the first quarter of 2005 in Korea and Japan for our small stage DualBeam products, as well as an increase in the sale of our wafer-level DualBeam systems.

Sales by Market

Net sales by market and as a percentage of total net sales were as follows (dollars in thousands):

	Thirteen Weeks Ended								Twenty-Six Weeks Ended
	July 3, 2005				July 4, 2004				July 3, 2005				July 4, 2004
Semiconductor	$	43,932	40.9	%	$	55,422	51.1	%	$	104,353	45.7	%	$	97,919	45.9	%
Industry and Institute	50,234		46.7	%	41,509		38.3	%	103,310		45.2	%	92,511		43.3	%
Data Storage	13,327		12.4	%	11,537		10.6	%	20,823		9.1	%	23,132		10.8	%
	$	107,493	100.0	%	$	108,468	100.0	%	$	228,486	100.0	%	$	213,562	100.0	%

Semiconductor

Product sales to the semiconductor market include both wafer-level and small stage DualBeam systems, defect analysis tools, mask repair and circuit editing FIB and DualBeam tools, as well as a number of component products.

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Sales in the semiconductor market decreased $11.5 million, or 20.7%, and increased $6.4 million, or 6.6%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. The decrease in the thirteen weeks ended July 3, 2005 compared to the same period of 2004 was due to weakness in the global semiconductor markets.  The increase in the twenty-six week period ended July 3, 2005 compared to the same period of 2004 was primarily due to an increase in the sale of our wafer level systems in the first quarter of 2005, as well as increased sales of small stage DualBeam products, primarily those introduced subsequent to the end of the first quarter of 2004.  We converted a significant amount of our backlog to revenue in the first quarter of 2005, which contributed to the increase in sales in the twenty-six weeks ended July 3, 2005 compared to the same period of 2004.  We expect the weakness in the semiconductor market to continue to negatively affect our sales in the third quarter of 2005.

Industry and Institute

Product sales to the industry and institute market primarily consist of SEMs, TEMs and small stage DualBeam systems. Customers in this market include universities, research institutes and corporate research and development labs. In addition, this market serves life sciences customers who are utilizing pathology applications of our TEMs and SEMs.  Within the industry and institute market, we see opportunity for increased sales related to applications in life sciences and nanotechnology.  Also, with the introduction of our small stage DualBeam products in mid-2003, we penetrated some customers who were previously using SEM tools. These products, which provide a broader range of solutions for our customers, provide greater gross margins than our SEM products.

Sales in the industry and institute market increased $8.7 million, or 21.0%, and $10.8 million, or 11.7%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004. These increases were mainly due to increases in sales of our small stage DualBeam products, primarily those introduced subsequent to the end of the first quarter of 2004, as well as increases in sales of our high resolution TEM products, partially offset by decreased demand due to the timing of government funding in the United States.

Data Storage

Product sales to the data storage market primarily consists of wafer and small stage DualBeam systems.

Sales in the data storage market increased $1.8 million, or 15.5%, and decreased $2.3 million, or 10.0%, respectively, in the thirteen and twenty-six week periods ended July 3, 2005, compared to the same periods of 2004.  The increase in the thirteen weeks ended July 3, 2005 compared to the same period of 2004 was primarily due to increased demand as new data storage manufacturing technology evolves.  The decrease in the twenty-six week period ended July 3, 2005 compared to the same period of 2004 was primarily due to lower sales in the first quarter of 2005, which resulted from weak orders at the end of 2004.

Cost of Sales and Gross Margin

Cost of sales includes manufacturing costs, such as materials, labor (both direct and indirect) and factory overhead, as well as all of the costs of our customer service function such as labor, materials, travel and overhead. We see four primary drivers affecting gross margin: product mix (including the effect of price competition), volume, cost reduction efforts and currency fluctuations.

Cost of sales increased $6.1 million, or 9.5%, to $70.8 million in the thirteen weeks ended July 3, 2005 compared to $64.7 million in the thirteen weeks ended July 4, 2004. Cost of sales increased $15.1 million, or 11.8%, to $142.9 million in the twenty-six weeks ended July 3, 2005 compared to $127.8 million in the twenty-six weeks ended July 4, 2004.

Cost of sales in the thirteen and twenty-six week periods ended July 3, 2005 include the following:

•a $3.2 million charge related to the write-down of inventory; and

•a $3.2 million charge related to capitalized software.

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These charges resulted primarily from capitalized software impairments and abandonment and lower of cost or market adjustments on inventory due to product obsolescence and reduced demand.  See also Notes 6 and 7 of Condensed Notes to Consolidated Financial Statements.

In addition to the above charges, these increases primarily were due to the increased revenues in the twenty-six week period discussed above and realized losses from our cash flow hedges totaling $1.0 million and $0.4 million, respectively, in the thirteen and twenty-six weeks ended July 3, 2005 compared to $0.2 million in both the thirteen and twenty-six week periods ended July 4, 2004.

Our gross margin (gross profit as a percentage of net sales) by segment was as follows:

	Thirteen Weeks Ended				Twenty-Six Weeks Ended
	July 3, 2005		July 4, 2004		July 3, 2005		July 4, 2004
Microelectronics	40.4	%	50.3	%	46.5	%	50.6	%
Electron Optics	32.2	%	28.9	%	32.4	%	31.2	%
Components	37.4	%	41.6	%	33.8	%	43.1	%
Service	28.5	%	30.9	%	27.5	%	32.1	%
Overall	34.1	%	40.3	%	37.5	%	40.2	%

The charges discussed above, which totaled $6.4 million, reduced our overall gross margin by 6.0 percentage points and 2.8 percentage points, respectively, and the microelectronics gross profit margin by 13.9 percentage points and 6.2 percentage points, respectively, in the thirteen and twenty-six week periods ended July 3, 2005.

Microelectronics

The decreases in gross margin in the microelectronics segment primarily were due to the charges related to asset impairment and write-downs discussed above, partially offset by increased volume and a shift in mix.

Electron Optics

The increases in margins in our electron optics segment primarily were due to a shift in mix to our high-resolution TEM products.  Gross margins were also affected by a 3.7 percentage point decrease and a 2.8 percentage point increase, respectively, for the thirteen and twenty-six week periods ended July 3, 2005, related to the relative change in the United States dollar compared to European currencies (without giving effect to our foreign currency hedges).

Components

The decreases in margins in our components segment primarily were due to a shift in mix between new component sales compared to sales related to our component refurbishments, as well as an overall decrease in volume and revenue to cover fixed costs.  The margins on our refurbishment work are typically greater than those on our new components.

Service

The decreases in margins in our service segment primarily were due to investments in head count and higher replacement part costs in the 2005 periods compared to the 2004 periods.

Research and Development Costs

Research and development (“R&D”) costs include labor, materials, overhead and payments to Philips and other third parties for research and development of new products and new software or enhancements to existing products and software and are presented net of subsidies received for such efforts.

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R&D costs were $15.9 million (14.8% of net sales) in the thirteen weeks ended July 3, 2005 compared to $13.1 million (12.1% of net sales) in the thirteen weeks ended July 4, 2004 and were $32.1 million (14.0% of net sales) in the twenty-six weeks ended July 3, 2005 compared to $26.7 million (12.5% of net sales) in the twenty-six week periods ended July 4, 2004.

R&D costs are reported net of subsidies and capitalized software development costs as follows:

	Thirteen Weeks Ended				Twenty-Six Weeks Ended
	July 3, 2005		July 4, 2004		July 3, 2005		July 4, 2004
Subsidies	$	1,079	$	1,882	$	2,496	$	3,561
Capitalized software development costs	$	—	$	205	$	—	$	495

Increased project costs contributed $0.6 million and $2.0 million, respectively, to the increases in the 2005 periods compared to the 2004 periods, the reductions in subsidies contributed $0.8 million and $1.1 million, respectively, and lower capitalized software costs contributed $0.2 million and $0.5 million, respectively, as detailed above. Increased labor and related charges contributed $0.5 million and $0.6 million, respectively, to the increases in the 2005 periods compared to the 2004 periods, while increased facility and utility charges contributed $0.4 million and $0.7 million, respectively, to the increases.

We anticipate that we will continue to invest in R&D at a similar percentage of revenue for the foreseeable future.  Accordingly, as revenues increase, we currently anticipate that R&D expenditures also will increase.  Actual future spending, however, will depend on market conditions.

Selling, General and Administrative Costs

Selling, general and administrative (“SG&A”) costs include labor, travel, outside services and overhead incurred in our sales, marketing, management and administrative support functions.  SG&A costs also include sales commissions paid to our employees as well as to our agents.

SG&A costs increased $2.4 million to $25.2 million for the thirteen weeks ended July 3, 2005 from $22.8 million for the thirteen weeks ended July 4, 2004.  Compensation costs related to annual salary increases contributed approximately $1.6 million to the SG&A increase.  Additionally, a $1.2 million increase in consulting and information technology costs, largely related to our ERP implementation, and a $1.2 million increase related to our accounts receivable reserves contributed to the increase.  These increases were offset in part by a $0.8 million gain from the SIM product line disposal, as well as a $0.3 million decrease in selling and marketing costs related to lower sales volumes.

For the twenty-six week period ended July 3, 2005, SG&A costs decreased $7.6 million to $50.5 million from $42.9 million for the twenty-six week period ended July 4, 2004.  Compensation costs related to bonuses and annual salary increased contributed approximately $5.2 million to the SG&A increase. Additionally, a $1.5 million increase in consulting and information technology costs, largely related to our ERP implementation, and a $1.4 million increase related to our accounts receivable reserves contributed to the increase. These increases were offset in part by a $0.8 million gain from the SIM product line disposal.

Amortization of Purchased Technology

Amortization of purchased technology was $1.5 million and $2.9 million in the thirteen and twenty-six week periods, respectively, ended July 3, 2005 compared to $1.4 million and $2.8 million, respectively, in the comparable periods of 2004.  In addition, in the thirteen and twenty-six week periods ended July 3, 2005, we recorded an impairment charge of $9.3 million against our purchased technology balance.  See also Note 6 of Condensed Notes to Consolidated Financial Statements. Following this write-down, our purchased technology balance at July 3, 2005 was $9.6 million and current amortization of purchased technology is approximately $0.7 million per quarter, which could increase if we acquire additional technology.

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Asset Impairment

In the second quarter of 2005, we took certain actions to align our cost structure with the current prevailing market conditions, primarily in the semiconductor markets.  The actions taken to date, which were necessary as a result of reduced business volumes, have resulted in decreases in our global workforce and also required us to evaluate our goodwill and long-lived assets for impairment.

We recorded asset impairment charges and write-offs totaling $15.9 million in the thirteen and twenty-six week periods ended July 3, 2005.  These charges are summarized as follows (in thousands):

	Asset Impairment
Purchased technology	$	9,328
Property, plant and equipment	5,705
Patents and other intangible assets	911
	$	15,944

For additional information on these impairments, see Note 6 of the Condensed Notes to Consolidated Financial Statements.

Restructuring, Reorganization and Relocation

As discussed in Note 6 of Condensed Notes to Consolidated Financial Statements, we have initiated global restructuring activities to realign our cost structure with current prevailing market conditions.  These actions include reductions in workforce, reorganization and relocation of employees as well as closure of facilities.  Some of these actions were initiated in the second quarter of 2005 with the remainder continuing through the end of 2005.  These costs are accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  Under SFAS No. 146, liabilities for costs associated with exit or disposal activities are recognized and measured at fair value in the period the liability is incurred.

In the second quarter of 2005, we expensed and paid $0.9 million in severance and relocation costs related to workforce reductions and reallocation of personnel geographically, which is included as a component of restructuring, reorganization and relocation expense. The expected remaining costs are estimated to be approximately $15 million. $10.0 million of the charge is expected to be cash expenditures for severance, relocation and other employee related costs and will be paid through the remainder of 2005 and $5.0 million in facility closure charges are expected to be incurred in the second half of 2005 with cash expenditures expected to continue through the lease expiration dates ending in 2010.

Our restructuring accruals as of July 3, 2005 are for prior year restructuring activities and include $0.4 million related to our fourth quarter 2002 restructuring activities and $0.3 million related to the abandonment of a lease in the second quarter of 2004.  Our abandoned lease accruals were increased in the second quarter of 2005 by $0.2 million based on revisions in our estimated sublease benefits and is included as a component of restructuring, reorganization and relocation expense. The current estimate accrued for cash to be paid related to abandoned leases of $0.7 million is net of estimated sublease payments to be received and will be paid over the respective lease terms through 2006.

The following table summarizes the charges, expenditures and write-offs and adjustments in the twenty-six weeks ended July 3, 2005 related to our restructuring accruals (in thousands):

Twenty-Six Weeks Ended July 3, 2005	Beginning Accrued Liability		Charged to Expense		Expend- Itures			Write-Offs and Adjust- Ments			Ending Accrued Liability
Severance, outplacement and related benefits for terminated employees	$	150	$	924	$	(1,060	)	$	(14	)	$	—
Abandoned leases, leasehold improvements and facilities	870		200		(377		)	—			693
	$	1,020	$	1,124	$	(1,437	)	$	(14	)	$	693

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The restructuring charges are based on estimates that are subject to change.  Workforce related charges could change because of shifts in timing, redeployment or changes in amounts of severance and outplacement benefits.  Facilities charges could change due to changes in sublease income. Our ability to generate sublease income is dependent upon lease market conditions at the time we negotiate the sublease arrangements. Variances from these estimates could alter our ability to achieve anticipated expense reductions in the planned timeframe and modify our expected cash outflows and working capital.

Other Income (Expense), Net

Other income (expense) items include interest income, interest expense, foreign currency gains and losses and other miscellaneous items.

Interest income represents interest earned on cash and cash equivalents, investments in marketable securities and, in the 2004 periods, a shareholder note receivable. Interest income was $1.9 million and $3.7 million in the thirteen and twenty-six week periods ended July 3, 2005, respectively, compared to $1.3 million and $2.4 million, respectively, in the comparable periods of 2004. This increase is the result of higher interest rates and higher cash and investment balances in the first two quarters of 2005 compared to the first two quarter of 2004. However, due to our repurchase of $70.0 million of our 5.5% convertible subordinated notes during the second quarter of 2005, we expect that interest income will decrease for the remainder of 2005. See the section titled “Liquidity and Capital Resources” below for a discussion of the changes in our cash and investment balances during the first two quarters of 2005.

Interest expense for both the 2005 and 2004 periods relates to our 5.5% convertible debt issued in August 2001.  The amortization of capitalized note issuance costs related to both of our convertible note issuances is also included as a component of interest expense. In connection with our repurchase of $70.0 million of our 5.5% convertible subordinated notes during the second quarter of 2005, we expensed $1.1 million of deferred note issuance costs as a component of interest expense. As a result of this repurchase, our interest expense will decrease in future periods. Assuming no further repurchases, amortization of our remaining convertible note issuance costs will total approximately $0.3 million per quarter through 2008.

Other, net, primarily consists of foreign currency gains and losses on transactions and realized and unrealized gains and losses on the changes in fair value of derivative contracts entered into to hedge these transactions.

The thirteen and twenty-six week periods ended July 3, 2005 include a charge of $0.8 million related to the write-down of one of our cost method investments.

The twenty-six week period ended July 4, 2004 also included unrealized losses of $2.7 million and realized gains of $1.4 million related to derivative contracts entered into to hedge U.S. sales of foreign subsidiaries.  Beginning in the second quarter of 2004, we achieved hedge treatment of such contracts and, accordingly, did not record any such unrealized gains or losses in other income (expense) subsequent to the first quarter of 2004.  However, in the second quarter of 2005, we recorded a charge of $0.2 million in other income/expense related to hedge ineffectiveness.

See also “Item 3: Qualitative and Quantitative Disclosures about Market Risk” below for a discussion of our foreign currency gains and losses and hedging activities.

Income Tax Expense

We recorded tax expense of $19.8 million and $21.5 million, respectively, for the thirteen and twenty-six weeks ended July 3, 2005. The tax expense does not reflect a benefit for current period losses in the United States as we have recorded a full valuation allowance against the United States deferred tax assets generated from the current year losses. An additional $14.3 million in tax expense was recorded in the thirteen weeks ended July 3, 2005 to record a valuation allowance for our existing United States deferred tax assets. Valuation allowances on deferred tax assets totaled $30.9 million and $4.9 million as of July 3, 2005 and December 31, 2004, respectively.

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Our income tax expense was equal to 103.2% of our pre-tax loss in the twenty-six week period ended July 3, 2005 compared to 35.0% in the comparable period of 2004, primarily due to no recognition of a tax benefit for our United States operating losses in the first half of 2005 and the recording of a valuation allowance as discussed above.

Our effective tax rate may differ from the United States federal statutory tax rate primarily as a result of the effects of state and foreign taxes, valuation allowances recorded against our deferred tax assets, adjustments to our tax contingency reserves and other factors.  In addition to the factors mentioned above, our effective income tax rate can be affected by changes in statutory tax rates in the United States and foreign jurisdictions, our ability or inability to utilize various carry forward tax items, changes in tax laws in the United States governing research and experimentation credits and other factors.

For the balance of 2005, we expect to record an abnormally high effective tax rate as we expect to have profits and related tax expense from our international operations, but losses in the United States for which we do not expect to record a tax benefit. This situation could continue in 2006 and beyond if we do not improve the profitability of the United States operations or develop a tax strategy that will be able to utilize the benefit of our net operating losses for tax purposes.

LIQUIDITY AND CAPITAL RESOURCES

Our sources of liquidity and capital resources as of July 3, 2005 consisted of $214.4 million of cash, cash equivalents, short-term restricted cash and short-term investments, $57.3 million in non-current investments, $4.4 million of long-term restricted cash, $21.2 million of available borrowings under our existing credit facilities, as well as potential future cash flows from operations. Restricted cash relates to deposits to back bank guarantees for customer prepayments that expire through 2008.  We believe that these sources of liquidity and capital will be sufficient to meet our expected operational and capital needs through at least 2006.

In the first two quarters of 2005, cash and cash equivalents decreased $41.7 million to $72.6 million as of July 3, 2005 from $114.3 million as of December 31, 2004 primarily as a result of the use of $71.8 million for the repurchase of $70.0 million of our 5.5% subordinated notes, $9.1 million used for the purchase of property, plant and equipment, $0.6 million used for the purchase of a cost-method investment and the negative impact of currency of $8.7 million.  These decreases were partially offset by $17.2 million provided by operations, $3.5 million of proceeds from the exercise of employee stock options and net sales of investments and marketable securities of $23.0 million.

Accounts receivable decreased $42.9 million to $116.9 million as of July 3, 2005 from $159.8 million as of December 31, 2004 primarily due to reduced revenue volumes in the first half of 2005 compared to the fourth quarter of 2004. This balance was also affected by a $6.7 million decrease related to changes in currency rates. Our days sales outstanding, calculated on a quarterly basis, was 99 days at July 3, 2005 compared to 101 days at December 31, 2004.

Inventories increased $4.2 million to $92.0 million as of July 3, 2005 compared to $87.8 million as of December 31, 2004. The increase primarily was due to a build-up of inventory to replenish supplies after stronger than anticipated sales in the fourth quarter of 2004 and build-up to support the new TEM products, partially offset by currency movements of approximately $9.6 million, the SIMS asset disposal of $4.0 million and the inventory write-off of $3.2 million. Our annualized inventory turnover rate, calculated on a quarterly basis, was 3.1 times for each of the quarters ended July 3, 2005 and July 4, 2004.

Expenditures for property, plant and equipment of $9.1 million in the first two quarters of 2005 primarily consisted of approximately $4.7 million for our new enterprise resource planning (“ERP”) system and $4.4 million for routine replacement of technology and other assets. We expect to continue to invest in capital equipment, customer evaluation systems and research and development equipment for applications development.  These expenditures were offset by write-offs of property, plant and equipment totaling $5.7 million in the second quarter of 2005 as described in more detail in Note 6 of Condensed Notes to Consolidated Financial Statements. We estimate our total capital expenditures in 2005 to be approximately $20 million, primarily for the development and introduction of new products and our new ERP system.

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In addition to our $225.0 million of convertible debt outstanding, we maintain $10.0 million unsecured, committed and $10.0 million unsecured, uncommitted bank borrowing facilities in the United States. We are also utilizing foreign unsecured, uncommitted bank borrowings for standby letters of credit and bank guarantees related to product sales totaling $9.0 million at July 3, 2005. These foreign facilities are secured by cash-backed restricted deposits of $20.0 million.  At July 3, 2005, a total of $21.2 million was available under these facilities.

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS

As noted above, this document contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. All forward-looking statements included in this document are based on information available to us as of the date hereof, and we assume no obligation to update these forward-looking statements. You are advised, however, to consult any further disclosures we make on related subjects in our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K filed with the SEC. Also note that we provide the following cautionary discussion of risks and uncertainties relevant to our businesses. These items are factors that we believe could cause our actual results to differ materially from expected and historical results. Other factors also could adversely affect us.

Our business is complex, and changes to the business may not achieve their desired benefits.

Our business is based on a myriad of technologies, encompassed in multiple different product lines, addressing various markets in different regions of the world.  A business of our size that is as complex as ours requires significant management time, attention and resources. In addition, significant changes to our business, such as changes in manufacturing, operations, product lines, market focus or organizational structure or focus, can be distracting, time-consuming and expensive.  These changes can have short-term adverse effects on our financial results, and may not provide their intended long-term benefits. Failure to achieve these benefits would have a material adverse impact on our business and financial results.

We operate in highly competitive industries and we cannot be certain that we will be able to compete successfully in such industries.

The industries in which we operate are intensely competitive. Established companies, both domestic and foreign, compete with each of our product lines. Many of our competitors have greater financial, engineering, manufacturing and marketing resources than we do, and may price their products very aggressively. Our significant competitors include:

•Microelectronics:  Applied Materials, Seiko, NP Test, JEOL, Hitachi and Carl Zeiss SMT AG; and

•Electron Optics: JEOL, Hitachi and Carl Zeiss SMT AG.

A substantial investment is required by customers to install and integrate capital equipment into their laboratories and production lines. As a result, once a manufacturer has selected a particular vendor’s capital equipment, the manufacturer generally relies on that equipment for a specific production line or process control application and frequently will attempt to consolidate its other capital equipment requirements with the same vendor. Accordingly, if a particular customer selects a competitor’s capital equipment, we expect to experience difficulty selling to that customer for a significant period of time.

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Our ability to compete successfully depends on a number of factors both within and outside of our control, including:

•price;

•product quality;

•breadth of product line;

•system performance;

•cost of ownership;

•global technical service and support; and

•success in developing or otherwise introducing new products.

We cannot be certain that we will be able to compete successfully on these or other factors, which could negatively impact our revenues, gross margins and net income in the future.

The loss of one or more of our key customers would result in the loss of significant net revenues.

A relatively small number of customers account for a large percentage of our net revenues. Our business will be seriously harmed if we do not generate as much revenue as we expect from these key customers, if we experience a loss of any of our key customers or if we suffer a substantial reduction in orders from these customers. Our ability to continue to generate revenues from our key customers will depend on our ability to introduce new products that are desirable to these customers.

Because we do not have long-term contracts with our customers, our customers may stop purchasing our products at any time, which makes it difficult to forecast our results of operations and to plan expenditures accordingly.

We do not have long-term contracts with our customers. Accordingly:

•customers can stop purchasing our products at any time without penalty;

•customers are free to purchase products from our competitors;

•we are exposed to competitive price pressure on each order; and

•customers are not required to make minimum purchases.

If we do not succeed in obtaining new sales orders from existing customers, our results of operations will be negatively impacted.

Because many of our shipments occur in the last month of a quarter, we are at risk of one or more transcations not being delivered according to forecast.

We have historically shipped approximately 60% of our products in the last month of each quarter.  As any one shipment may be significant to meet our quarterly sales projection, any slippage of shipments into a subsequent quarter may result in our not meeting our quarterly sales projection.

We rely on a limited number of parts, components and equipment manufacturers. Failure of any of these suppliers to provide us with quality products in a timely manner could negatively affect our revenues and results of operations.

Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business. We currently use numerous vendors to supply parts, components and subassemblies for the manufacture and support of our products. Some key parts, however, may only be obtained from a single supplier or a limited group of suppliers. In particular, we rely on Philips Enabling Technologies Group, B.V., or Philips ETG, Frencken Mechatronics B.V. and Gatan, Inc. for our supply of mechanical parts and subassemblies and Neways Electronics, N.V. and Benchmark Electronics for some of our electronic subassemblies. In addition, some of our suppliers rely on sole suppliers.  As a result of this concentration of key suppliers, our results of operations may be materially and adversely affected if we do not timely and cost-effectively receive a sufficient quantity of parts to meet our

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production requirements or if we are required to find alternative suppliers for these supplies. We may not be able to expand our supplier group or to reduce our dependence on single suppliers. From time to time, we have experienced supply constraints with respect to the mechanical parts and subassemblies produced by Philips ETG. If Philips ETG is not able to meet our supply requirements, these constraints may affect our ability to deliver products to customers in a timely manner, which could have an adverse effect on our results of operations.

We rely on a limited number of equipment manufacturers to develop and supply the equipment we use to manufacture our products. The failure of these manufacturers to develop or deliver quality equipment on a timely basis could have a material adverse effect on our business and results of operations. In addition, because we only have a few equipment suppliers, we may be more exposed to future cost increases for this equipment.

The loss of key management or our inability to attract and retain sufficient numbers of managerial, engineering and other technical personnel could have a material adverse effect on our business and results of operations.

Our continued success will depend, in part, on our ability to continue to retain and attract key managerial, engineering and technical personnel.Our growth is dependent on our ability to attract new, highly skilled and qualified technical personnel, in addition to personnel that can implement and monitor our financial and managerial controls and reporting systems. Attracting qualified personnel is difficult and our recruiting efforts may not be successful. Specifically, our product generation efforts depend on hiring and retaining qualified engineers. The market for qualified engineers is very competitive. In addition, experienced management and technical, marketing and support personnel in the information technology industry are in high demand, and competition for such talent is intense. The loss of key personnel, or our inability to attract key personnel, could have a material adverse effect on our business, prospects, financial condition or results of operations.

Philips Business Electronics International B.V. has significant influence on all company shareholder votes and may have different interests than our other shareholders.

As of July 3, 2005, Philips Business Electronics International B.V., or PBE, a subsidiary ofKoninklijke Philips Electronics NV, owned approximately 25% of our outstanding common stock. In addition, Jan C. Lobbezoo, Executive Vice President and Chief Financial Officer of Philips Semiconductors International B.V., an affiliate of Philips, serves on our Board of Directors.  As a result, PBE has significant influence on matters submitted to our shareholders for approval, including proposals regarding:

•any merger, consolidation or sale of all or substantially all of our assets; and

•the election of members to our board of directors.

In addition to its significant influence, PBE’s interests may be significantly different from the interests of other owners of our common stock, holders of our options to purchase common stock and holders of our debt securities.

If our customers cancel or reschedule orders or if an anticipated order for even one of our systems is not received in time to permit shipping during a certain fiscal period, our operating results for that fiscal period may fluctuate and our business and financial results for such period could be materially and adversely affected.

Our customers are able to cancel or reschedule orders, generally with limited or no penalties, depending on the product’s stage of completion. The amount of purchase orders at any particular date, therefore, is not necessarily indicative of sales to be made in any given period. Our build cycle, or the time it takes us to build a product to customer specifications, typically ranges from one to six months. During this period, the customer may cancel the order, although generally we will receive a cancellation fee based on the stage of the build cycle reached. In addition, we derive a substantial portion of our net sales in any fiscal period from the sale of a relatively small number of high-priced systems, with a large portion in the last month of the quarter. As a result, the timing of revenue recognition for a single transaction could have a material effect on our revenue

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and results of operations for a particular fiscal period. We did not have significant order cancellations during the twenty-six weeks ended July 3, 2005 or during the year ended December 31, 2004.

Due to these factors, our net revenues and results of operations have fluctuated in the past and are likely to fluctuate significantly in the future on a quarterly and annual basis. It is likely that in some future quarter or quarters our results of operations will be below the expectations of public market analysts or investors. In such event, the market price of our common stock may decline significantly.

We have long sales cycles for our systems, which may cause our results of operations to fluctuate and could negatively impact our stock price.

Our sales cycle can be 12 months or longer and is unpredictable. Variations in the length of our sales cycle could cause our net sales and, therefore, our business, financial condition, results of operations and cash flows, to fluctuate widely from period to period. These variations could be based on factors partially or completely outside of our control.

The factors that could affect the length of time it takes us to complete a sale depend on many elements, including:

•the efforts of our sales force and our independent sales representatives;

•changes in the composition of our sales force, including the departure of senior sales personnel;

•the history of previous sales to a customer;

•the complexity of the customer’s manufacturing processes;

•the economic environment;

•the internal technical capabilities and sophistication of the customer; and

•the capital expenditure budget cycle of the customer.

As a result of these and a number of other factors that could influence sales cycles with particular customers, the period between initial contact with a potential customer and the time when we recognize revenue from that customer, if ever, may vary widely. Our sales cycle also extends in situations where the sale involves developing new applications for a system or technology.

The industries in which we sell our products are cyclical, which may cause our results of operations to fluctuate.

Our business depends in large part on the capital expenditures of seimconductor, industry and institute and data storage customers, which accounted for the following percentages of our net sales (product and service) for the periods indicated:

	Twenty-Six Weeks Ended
	July 3, 2005		July 4, 2004
Semiconductor	45.7	%	45.9	%
Industry and Institute	45.2	%	43.3	%
Data Storage	9.1	%	10.8	%
	100.0	%	100.0	%

The data storage and semiconductor industries are cyclical. These industries have experienced significant economic downturns at various times in the last decade. Such downturns have been characterized by diminished product demand, accelerated erosion of average selling prices and production overcapacity. A downturn in one or more of these industries, or the businesses of one or more of our customers, could have a material adverse effect on our business, prospects, financial condition and results of operations. The industry and institute market also is affected by overall economic conditions, but is not as cyclical as the semiconductor and data storage markets.

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In the first and second quarters of 2005, the semiconductor equipment market experienced weakness. Global economic conditions continue to be volatile and slower growth or reduced demand for our customers’ products in the future would cause our business to decline. During downturns, our sales or margins may decline. As a capital equipment provider, our revenues depend in large part on the spending patterns of our customers, who often delay expenditures or cancel orders in reaction to variations in their businesses or general economic conditions. Because a high proportion of our costs are fixed, we have a limited ability to reduce expenses quickly in response to revenue shortfalls. In an industry of prolonged economic downturn, we may not be able to reduce our significant fixed costs, such as manufacturing overhead, capital equipment or research and development costs.  As such, we may experience gross margin erosion and a decline in our earnings.

Our customers experience rapid technological changes, with which we must keep pace, but we may be unable to introduce new products on a timely and cost-effective basis to meet such changes.

The data storage, semiconductor and industry and institute industries experience rapid technological change and new product introductions and enhancements. Our ability to remain competitive depends in large part on our ability to develop, in a timely and cost-effective manner, new and enhanced systems at competitive prices and to accurately predict technology transitions. In addition, new product introductions or enhancements by competitors could cause a decline in our sales or a loss of market acceptance of our existing products. Increased competitive pressure also could lead to intensified price competition, resulting in lower margins, which could materially adversely affect our business, prospects, financial condition and results of operations.

Our success in developing, introducing and selling new and enhanced systems depends on a variety of factors, including:

•selection and development of product offerings;

•timely and efficient completion of product design and development;

•timely and efficient implementation of manufacturing processes;

•effective sales, service and marketing; and

•product performance in the field.

Because new product development commitments must be made well in advance of sales, new product decisions must anticipate both the future demand for products under development and the equipment required to produce such products. We cannot be certain that we will be successful in selecting, developing, manufacturing and marketing new products or in enhancing existing products.

The process of developing new high technology capital equipment products and services is complex and uncertain, and failure to accurately anticipate customers’ changing needs and emerging technological trends and to develop or obtain appropriate intellectual property could significantly harm our results of operations. We must make long-term investments and commit significant resources before knowing whether our predictions will result in products that the market will accept. For example, we have invested significant resources in the development of three dimensional metrology products for semiconductor wafer manufacturing. If three-dimensional metrology is not widely accepted or if we fail to develop products that are accepted by the marketplace, our long-term growth could be harmed. To the extent that a market does not develop for a product, we may decide to discontinue or modify the product.  These actions could involve significant costs and/or require us to take charges in future periods. If these products are accepted by the marketplace, sales of our new products may cannibalize sales of our existing products. Further, after a product is developed, we must be able to manufacture sufficient volume quickly and at low cost. To accomplish this objective, we must accurately forecast production volumes, mix of products and configurations that meet customer requirements. If we are not successful in making accurate forecasts, our business and results of operations could be significantly harmed.

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Because we have significant operations outside of the United States, we are subject to political, economic and other international conditions that could result in increased operating expenses and regulation of our products and increased difiiculty in maintaining operating and financial controls.

Since a significant portion of our operations occur outside of the United States, our revenues and expenses are impacted by foreign economic and regulatory conditions.  In the twenty-six weeks ended July 3, 2005 and in the year ended December 31, 2004, approximately 71% and 62%, respectively, of our revenues came from outside of the United States. We have manufacturing facilities in Brno, Czech Republic and Eindhoven, the Netherlands and sales offices in several other countries. In addition, approximately 31% of our sales in the twenty-six weeks ended July 3, 2005 and in the year ended December 31, 2004 were derived from sales in Asia. In recent years, Asian economies have been highly volatile and recessionary, resulting in significant fluctuations in local currencies and other instabilities. Instabilities in Asian economies may continue and recur in the future or instability could occur in other foreign economies, any of, which could have a material adverse effect on our business, prospects, financial condition, margins and results of operations.

Moreover, we operate in approximately 45 countries. Some of our global operations are geographically isolated, are distant from corporate headquarters and/or have little infrastructure support. Therefore maintaining and enforcing operating and financial controls can be difficult.  Failure to maintain or enforce controls could have a material adverse effect on our control over service inventories, quality of service, customer relationships and financial reporting.

Our exposure to the business risks presented by Asian economies and other foreign economies will increase to the extent we continue to expand our global operations. International operations will continue to subject us to a number of risks, including:

•longer sales cycles;

•multiple, conflicting and changing governmental laws and regulations;

•protectionist laws and business practices that favor local companies;

•price and currency exchange rates and controls;

•difficulties in collecting accounts receivable; and

•political and economic instability.

If third parties assert that we violate their intellectual property rights, our business and results of operations may be materially adversely affected.

Several of our competitors hold patents covering a variety of technologies that may be included in some of our products. In addition, some of our customers may use our products for applications that are similar to those covered by these patents. From time to time, we and our respective customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. To date, none of these allegations has resulted in litigation. Our competitors or other entities may, however, assert infringement claims against us or our customers in the future with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.

We also may face greater exposure to claims of infringement in the future because PBE no longer is our majority shareholder. As a result of PBE’s reduction of ownership of our common stock in 2001, we no longer receive the benefit of many of the Philips patent cross-licenses that we previously received.

If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, these potential infringement claims could have a material adverse effect on our business, prospects, financial condition and results of operations.

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We may not be able to enforce our intellectual property rights, especially in foreign countries, which could materially adversely affect our business.

Our success depends in large part on the protection of our proprietary rights. We incur significant costs to obtain and maintain patents and defend our intellectual property. We also rely on the laws of the United States and other countries where we develop, manufacture or sell products to protect our proprietary rights. We may not be successful in protecting these proprietary rights, these rights may not provide the competitive advantages that we expect, or other parties may challenge, invalidate or circumvent these rights.

Further, our efforts to protect our intellectual property may be less effective in some countries where intellectual property rights are not as well protected as they are in the United States. Many United States companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. We derived approximately 71% and 62%, respectively, of our sales from foreign countries in the twenty-six weeks ended July 3, 2005 and in the year ended December 31, 2004. If we fail to adequately protect our intellectual property rights in these countries, our business may be materially adversely affected.

Infringement of our proprietary rights could result in lost sales opportunities and increased litigation costs, both of which could have a material adverse effect on our business, prospects, financial condition and results of operations.

We are substantially leveraged, which could adversely affect our ability to adjust our business to respond to competitive pressures and to obtain sufficient funds to satisfy our future manufacturing capacity and research and development needs.

We have significant indebtedness. At July 3, 2005, we had total convertible long-term debt of approximately $225.0 million, which could all become due and payable between June and August 2008.

The degree to which we are leveraged could have important consequences, including, but not limited to, the following:

•our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate or other purposes may be limited;

•the dilutive effects on our shareholders as a result of the ability of the 5.5% convertible bond holders to convert these notes into an aggregate of 1,514,540 shares of our common stock;

•the dilutive effects on our shareholders as a result of the up to 5,528,527 shares of common stock that would be issued in the event we elect to settle all or a portion of the Zero Coupon Convertible Notes in shares upon the bondholders’ election to convert the notes once certain stock price metrics are met;

•a substantial portion of our cash flow from operations will be dedicated to the payment of the principal of, and interest on, our indebtedness; and

•we may be more vulnerable to economic downturns, less able to withstand competitive pressures and less flexible in responding to changing business and economic conditions.

Our ability to pay interest and principal on our debt securities, to satisfy our other debt obligations and to make planned expenditures will be dependent on our future operating performance, which could be affected by changes in economic conditions and other factors, some of which are beyond our control. A failure to comply with the covenants and other provisions of our debt instruments could result in events of default under such instruments, which could permit acceleration of the debt under such instruments and in some cases acceleration of debt under other instruments that contain cross-default or cross-acceleration provisions. We believe that cash flow from operations will be sufficient to cover our debt service and other requirements. If we are at any time unable to generate sufficient cash flow from operations to service our indebtedness, however, we may be required to attempt to renegotiate the terms of the instruments relating to the indebtedness, seek to refinance all or a portion of the indebtedness or obtain additional financing. There can be no assurance that we will be able to successfully renegotiate such terms, that any such refinancing would be possible or that any additional financing could be obtained on terms that are favorable or acceptable to us.

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Any failure by us to execute planned cost reductions successfully could result in total costs and expenses that are greater than expected.

Historically, we have undertaken restructuring plans to bring operational expenses to appropriate levels for our business. We may have further workforce reductions or rebalancing actions in the future. Significant risks associated with these actions and other workforce management issues that may impair our ability to achieve anticipated cost reductions or that may otherwise harm our business include delays in implementation of anticipated workforce reductions in highly regulated locations outside of the United States, particularly in Europe and Asia, redundancies among restructuring programs, decreases in employee morale and the failure to meet operational targets due to the loss of employees, particularly sales employees.

We may have underestimated past restructuring charges or we may incur future restructuring charges, either of which may adversely impact our results of operations.

Over the last few years, we initiated a series of restructurings of our operations involving, among other things, the reduction of our workforce and the consolidation of excess facilities. The charges in connection with these restructurings are only estimates and may not be accurate.  As part of these restructurings, we ceased to use certain of our leased facilities and, accordingly, we have negotiated, and are continuing to negotiate, certain lease terminations and/or subleases of our facilities. We cannot predict when or if we will be successful in negotiating lease termination agreements or subleases of our facilities on terms acceptable to us. If we are not successful negotiating terms acceptable to us, or at all, we may be required to materially increase our restructuring and related expenses in future periods.  Further, if we have further reductions to our workforce or consolidate additional facilities in the future, we may incur additional restructuring and related expenses, which could have a material adverse effect on our business, financial condition or results of operations.

FASB’s adoption of Statement 123(R) will cause changes to existing accounting pronouncements or taxation rules or practices.  This may affect our reported results of operations or how we compensate our employees and conduct our business.

On October 13, 2004, the FASB adopted Statement 123(R), “Share-Based Payment,” which will require us, starting in fiscal 2006, to measure compensation costs for all stock based compensation (including stock options and our employee stock purchase plan, as currently constructed) at fair value and take a compensation charge equal to that value. If the FASB’s Statement 123(R) was in effect for the periods reported in this report, we would have had to reduce net income by approximately $5.1 million and $8.0 million, net of tax, respectively, for the thirteen and twenty-six weeks ended July 3, 2005 and $2.4 million and $4.7 million, respectively, in the comparable periods of 2004.

Also, a change in accounting pronouncements or taxation rules or practices can have a significant effect on our reported results. Other new accounting pronouncements or taxation rules and varying interpretations of accounting pronouncements or taxation practice have occurred and may occur in the future. This change to existing rules, future changes, if any, or the questioning of current practices may adversely affect our reported financial results, change the mix of compensation we pay to our employees or change the way we conduct our business.

Due to our extensive international operations and sales, we are exposed to foreign currency exchange rate risks that could adversely affect our revenues, gross margins and results of operations.

A significant portion of our sales and expenses are denominated in currencies other than the United States dollar, principally the euro. Approximately 15% to 20% of our revenue in a given year is denominated in euros, while approximately half of our expenses are denominated in euros.  Particularly as a result of this imbalance, changes in the exchange rate between the United States dollar and foreign currencies, especially the euro, can impact our revenues, gross margins, results of operations and cash flows.

We enter into foreign forward exchange contracts to partially mitigate the impact of specific cash, receivables or payables positions denominated in foreign currencies.  We also enter into various forward extra contracts (a combination of a foreign forward exchange contract and an option), as well as standard option contracts, to

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partially mitigate the impact of changes in the euro against the dollar on our European operating results. These contracts are considered derivatives.  We are required to carry all open derivative contracts on our balance sheet at fair value. When specific accounting criteria have been met, derivative contracts can be designated as hedging instruments and changes in fair value related to these derivative contracts are recorded in other comprehensive income, rather than net income, until the underlying hedged transaction affects net income. We are required to record changes in fair value for derivatives not designated as hedges in net income in the current period.  Prior to the second quarter of fiscal 2004, none of our derivative contracts were designated as hedges and all realized and unrealized gains and losses were recognized in net income in the current period.  Our ability to designate derivative contracts as hedges significantly reduces the volatility in our operating results due to changes in the fair value of the derivative contracts.

Achieving hedge designation is based on evaluating the effectiveness of the derivative contracts’ ability to mitigate the foreign currency exposure of the linked transaction. We are required to monitor the effectiveness of all new and open derivative contracts designated as hedges on a quarterly basis.  Based on our evaluation in the second quarter of 2005, we recorded a charge of $0.2 million in other income/expense related to hedge ineffectiveness. Failure to meet the hedge accounting requirements could result in the requirement to record deferred and current realized and unrealized gains and losses into net income in the current period. This failure could result in significant fluctuations in operating results. In addition, we will continue to recognize unrealized gains and losses related to the changes in fair value of derivative contracts not designated as hedges in the current period net income. Accordingly, the related impact to operating results may be recognized in a different period than the foreign currency impact of the linked asset, liability or transaction.

The hedging transactions we undertake limit our exposure to changes in the dollar/euro exchange rate. The hedges have a bias to protect us as the dollar weakens, but also provide us with some flexibility if the dollar strengthens. Foreign currency losses recorded in other income/expense, inclusive of the impact of derivatives, totaled $0.1 million and $0.3 million, respectively, for the thirteen and twenty-six weeks ended July 3, 2005 and $0 and $2.4 million, respectively, in the comparable periods of 2004.

Our acquisition and investment strategy subjects us to risks associated with evaluating and pursuing these opportunities and integrating these businesses.

In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies from external sources.  As part of this effort, we may make acquisitions of, or make significant investments in, businesses with complementary products, services and/or technologies.  Acquisitions can involve numerous risks, including management issues and costs in connection with the integration of the operations and personnel, technologies and products of the acquired companies, the possible write-downs of impaired assets, and the potential loss of key employees of the acquired companies.  The inability to effectively manage any of these risks could seriously harm our business. Additionally, difficulties in integrating any potential acquisitions into our internal control structure could result in a failure of our internal control over financial reporting, which, in turn, could create a material weakness.

Our investments may not prove to be successful and we could lose all or a portion of our investments and/or could be required to take write-offs related to these investments.  Further, to the extent we make investments in entities that we control, our financial results will, to an extent, reflect the financial results of the controlled entity.

We are planning to implement certain systems changes that might disrupt our operations.

Our ability to design, manufacture, market and service products and systems is dependent on information technology systems that encompass all of our major business functions. We plan to implement a comprehensive enterprise resource planning (“ERP”) software system in 2006.  This new ERP system will cover many aspects of our business.  If we encounter delays or difficulties in implementing the new ERP system, it could adversely affect our ability to do the following in a timely manner: manage and replenish inventory, fulfill and process orders, manufacture and ship products in a timely manner, invoice and collect receivables, place purchase orders and pay invoices, coordinate sales and marketing activities, prepare our financial statements, manage our accounting systems and controls and otherwise carry on our business in the

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ordinary course. Any such disruption could adversely affect our business, prospects, financial condition and results of operations. Delays in implementation may result in additional costs. Moreover, delay or difficulties in implementation of the ERP system could result in a failure of our internal control over financial reporting, which, in turn, could create a material weakness.

Terrorist acts or acts of war and natural disasters may seriously harm our business and revenues, costs and expenses and financial condition.

Terrorist acts, acts of war and natural disasters (wherever located around the world) may cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and customers, any and all of which could significantly impact our revenues, expenses and financial condition. This impact could be disproportionately greater on us than on other companies as a result of our significant international presence. The terrorist attacks that took place in the United States on September 11, 2001 were unprecedented events that have created many economic and political uncertainties, some of which may materially harm our business and results of operations. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways that cannot presently be predicted. We are largely uninsured for losses and interruptions caused by terrorist acts, acts of war and natural disasters.

Unforeseen environmental costs could impact our future net earnings.

Some of our operations use substances that are regulated by various federal, state and international laws governing the environment. We could be subject to liability for remediation if we do not handle these substances in compliance with applicable laws. It is our policy to apply strict standards for environmental protection to sites inside and outside the United States, even when not subject to local government regulations. We will record a liability for environmental remediation and related costs when we consider the costs to be probable and the amount of the costs can be reasonably estimated.

Provisions of our charter documents could make it more difficult for a third party to acquire us even if the offer may be considered beneficial by our shareholders.

Our certificate of incorporation and bylaws contain provisions, which could make it harder for a third party to acquire us without the consent of our Board of Directors. Among other things, our Board of Directors has adopted a shareholder rights plan, or “poison pill,” which would significantly dilute the ownership of a hostile acquirer. These provisions make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial by our shareholders.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Rate Risk

A large portion of our business is conducted outside of the United States through a number of foreign subsidiaries. Each of the foreign subsidiaries keeps its accounting records in its respective local currency. These local currency denominated accounting records are translated at exchange rates that fluctuate up or down from period to period and consequently affect our consolidated results of operations and financial position. The major foreign currencies in which we experience periodic fluctuations are the euro, the Czech koruna, the Japanese yen and the British pound sterling.  Although for each of the last three years more than 55% of our sales occurred outside of the United States, a large portion of these foreign sales were denominated in United States dollars and euros.

In addition, because of our substantial research, development and manufacturing operations in Europe, we incur a greater proportion of our costs in Europe than the revenue we derive from sales in that geographic region.  Our raw materials, labor and other manufacturing costs are primarily denominated in United States dollars, euros and Czech korunas.  This situation negatively affects our gross margins and results of operations when the dollar weakens in relation to the euro or koruna.  A strengthening of the dollar in relation to the euro or koruna would have a positive effect on our gross margins and results of operations.  Movement of Asian currencies in relation

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to the dollar and euro also can affect our reported sales and results of operations because we derive more revenue than we incur costs from the Asia-Pacific region. In addition, several of our competitors are based in Japan and a weakening of the Japanese yen has the effect of lowering their prices relative to ours.

Assets and liabilities of foreign subsidiaries are translated using the exchange rates in effect at the balance sheet date. The resulting translation adjustments decreased shareholders’ equity and comprehensive income in the twenty-six weeks ended July 3, 2005 by $20.4 million.  Holding other variables constant, if the United States dollar weakened by 10% against all currencies that we translate, shareholders’ equity would increase by approximately $14.9 million as of July 3, 2005. Holding other variables constant, if the United States dollar strengthened by 10% against all currencies that we translate, shareholders’ equity would decrease by approximately $12.2 million as of July 3, 2005.

Risk Mitigation

We use derivatives to mitigate financial exposure resulting from fluctuations in foreign currency exchange rates. When specific accounting criteria have been met, changes in fair values of derivative contracts relating to anticipated transactions are recorded in other comprehensive income, rather than net income, until the underlying hedged transaction affects net income. Changes in fair value for derivatives not designated as hedging instruments are recognized in net income in the current period.

As of July 3, 2005, the aggregate notional amount of our outstanding derivative contracts was $127.6 million, which contracts have varying maturities through March 2006.

Holding other variables constant, if the United States dollar weakened by 10%, the market value of our foreign currency contracts outstanding as of July 3, 2005 would increase by approximately $9.1 million. The increase in value relating to the forward sale or purchase contracts would, however, be substantially offset by the revaluation of the transactions being hedged. A 10% increase in the United States dollar relative to the hedged currencies would have a similar, but negative, effect on the value of our foreign currency contracts, substantially offset again by the revaluation of the transactions being hedged.

We do not enter into derivative financial instruments for speculative purposes.

Balance Sheet Related

We attempt to mitigate our currency exposures for recorded transactions by using forward exchange contracts to reduce the risk that our future cash flows will be adversely affected by changes in exchange rates.  We enter into forward sale or purchase contracts for foreign currencies to hedge specific cash, receivables or payables positions denominated in foreign currencies. Changes in fair value of derivatives entered into to mitigate the foreign exchange risks related to these balance sheet items are recorded in other income/expense currently together with the transaction gain or loss from the hedged balance sheet position.

Cash Flow Hedges

Beginning in July 2003, we began using foreign forward extra contracts (a combination of forward exchange and option contracts) and then later option contracts to hedge certain anticipated foreign currency exchange transactions. The foreign exchange hedging structure is set up on a twelve-month time horizon. The hedging transactions we undertake primarily limit our exposure to changes in the dollar/euro exchange rate. The forward extra contract hedges have a bias to protect us as the dollar weakens, but also provide us with some flexibility if the dollar strengthens.

Prior to the second quarter of 2004, we did not meet the criteria to treat these derivatives as hedges and, accordingly, the changes in fair value were recorded in net income.  We recorded unrealized losses of $2.7 million and realized gains of $1.4 million related to these contracts in the twenty-six week period ended July 4, 2004 as a component of other income.

In the second quarter of 2004, these derivatives met the criteria to be designated as hedges and, prospectively, we record the change in fair value of these hedge contracts relating to anticipated transactions in other comprehensive income rather than net income until the underlying hedged transaction affects net

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income. We recognized realized losses of $0.4 million and $0.2 million, respectively, in the twenty-six week periods ended July 3, 2005 and July 4, 2004 in cost of sales related to hedge results. As of July 3, 2005, $1.7 million of deferred unrealized net losses on outstanding derivatives have been recorded in other comprehensive income and are expected to be reclassified to net income during the next twelve months as a result of the underlying hedged transactions also being recorded in net income.  In the second quarter of 2005, we recorded a charge of $0.2 million in other income (expense) related to hedge ineffectiveness.

Interest Rate Risk

Our exposure to market risk for changes in interest rates primarily relate to our investments.  Since we have no variable interest rate debt outstanding at July 3, 2005, our interest expense is relatively fixed and not affected by changes in interest rates.

The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This objective is accomplished by making diversified investments, consisting only of investment grade securities.

Cash, Cash Equivalents and Restricted Cash

As of July 3, 2005, we held cash and cash equivalents of $72.7 million and short-term restricted cash of $15.6 million that consist of cash and highly liquid short-term investments having maturity dates of no more than 90 days at the date of acquisition. Declines of interest rates over time would reduce our interest income from our highly liquid short-term investments. A decrease in interest rates of one percentage point would cause a corresponding decrease in annual interest income by approximately $0.9 million assuming our cash and cash equivalent balances at July 3, 2005 remained constant. Due to the nature of our highly liquid cash equivalents, an increase in interest rates would not materially change the fair market value of our cash and cash equivalents.

Fixed Rate Debt Securities

As of July 3, 2005, we held short and long-term fixed rate investments of $78.0 million that consisted of corporate notes and bonds and government-backed securities. These investments are recorded on our balance sheet at fair value based on quoted market prices.  Unrealized gains/losses resulting from changes in the fair value are recorded, net of tax, in shareholders’ equity as a component of other comprehensive income (loss).  Interest rate fluctuations impact the fair value of these investments, however, given our ability to hold these investments until maturity or until the unrealized losses recover, we do not expect these fluctuations to have a material impact on our results of operations, financial position or cash flows.  Declines in interest rates over time would reduce our interest income from our short-term investments, as our short-term portfolio is re-invested at current market interest rates. A decrease in interest rates of one percentage point would cause a corresponding decrease in our annual interest income from these items of less than $0.8 million assuming our investment balances at July 3, 2005 remained constant.

Variable Rate-Notes

As of July 3, 2005, we held variable-rate notes of $105.4 million.  Given the highly-liquid nature of variable-rate notes, cost is considered to approximate fair value for these securities and their fair value is not significantly impacted by interest rate fluctuations. Declines in interest rates over time would reduce our interest income from our investments in variable-rate notes, as interest rates are reset periodically to current market interest rates. A decrease in interest rates of one percentage point would cause a corresponding decrease in our annual interest income from these items of less than $1.1 million assuming our investment balances at July 3, 2005 remained constant.

Fair Value of Convertible Debt

The fair market value of our fixed rate convertible debt is subject to interest rate risk.  Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise.  The interest rate changes affect the fair market value of our long-term debt, but do not impact earnings or cash flows.  At July 3, 2005, we had $225.0 million of fixed rate convertible debt outstanding. Based on open market trades, we have determined that the fair market value of our long-term fixed interest rate debt was approximately $222.0 million at July 3, 2005.

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Item 4.Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management has evaluated, under the supervision and with the participation of our President and Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (Exchange Act). Based on that evaluation, our Chairman, President and Chief Executive Officer and our Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chairman, President and Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Controls

There has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting. 

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Part II - - Other Information

Item 4.Submission of Matters to a Vote of Security Holders

The following actions were taken at our annual meeting of shareholders, which was held on May 19, 2005:

1.The shareholders elected the nine nominees for director to our Board of Directors.  The nine directors elected, along with the voting results are as follows:

Name	No. of Shares Voting For	No. of Shares Withheld Voting
Dr. Michael J. Attardo	31,006,498	1,257,421
Lawrence A. Bock	30,827,351	1,436,568
Wilfred J. Corrigan	30,308,243	1,955,676
Thomas F. Kelly	31,001,664	1,262,255
Dr. William W. Lattin	30,721,947	1,541,972
Jan C. Lobbezoo	31,250,632	1,013,287
Dr. Gerhard Parker	30,727,994	1,535,925
James T. Richardson	30,472,896	1,791,023
Vahé A. Sarkissian	30,762,285	1,501,634
Donald R. VanLuvanee	30,723,339	1,540,580

2.The shareholders approved the amendments to the 1995 Stock Incentive Plan to increase the number of shares of our common stock reserved for issuance under the plan from 7,000,000 to 8,000,000 as follows:

No. of Shares Voting For:	No. of Shares Voting Against:	No. of Shares Abstaining:	No. of Broker Non-Votes:
20,840,814	5,589,127	491,347	5,342,631

3.The shareholders approved an amendment to the FEI Employee Share Purchase Plan to increase the number of shares of our common stock reserved for issuance under the plan from 1,450,000 to 1,950,000 as follows:

No. of SharesVoting For:	No. of Shares Voting Against:	No. of Shares Abstaining:	No. of Broker Non-Votes:
25,233,688	1,199,015	488,585	5,342,631

Item 6.Exhibits

The following exhibits are filed herewith or incorporated by reference hereto and this list is intended to constitute the exhibit index:

3.1Third Amended and Restated Articles of Incorporation. (1)

3.2Amended and Restated Bylaws, as amended on April 17, 2003. (2)

10.1Rights Agreement dated July 21, 2005, between FEI Company and Mellon Investor Services, LLC. (3)

31Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.

32Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.

(1)Incorporated by reference to the registrant’s quarterly report on Form 10-Q for the quarter ended September 28, 2003.

(2)Incorporated by reference to the registrant’s quarterly report on Form 10-Q for the quarter ended March 30, 2003.

(3)Incorporated by reference to the registrant’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on July 27, 2005.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	FEI COMPANY
Dated:  August 12, 2005	/s/ VAHÉ A. SARKISSIAN
	Vahé A. Sarkissian
	Chief Executive Officer and President
	(Principal Executive Officer)
	/s/ RAYMOND A. LINK
	Raymond A. Link
	Executive Vice President and
	Chief Financial Officer
	(Principal Financial Officer)

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